Lacker and Hoenig (two relatively hawkish FOMC officials) yesterday warned that Fed balance sheet must at some point be curbed

In comments yesterday, Richmond Fed President Lacker (who has been a relatively hawkish FOMC member) yesterday remained optimistic that economic activity would bottom out and begin expanding sometime later this year. Relative to comments he made about a month ago, he seemed more confident about the economic outlook, partly by highlighting the resilience of the consumer and the power of monetary policy as two important stabilizing forces that will help contribute to a recovery. Despite severe declines in consumer wealth, he considered that consumers might be growing more confident in their future income prospects, which should eventually lead to firmer spending. Also, he thought that “housing activity may no longer be declining rapidly” and noted data which had tentatively suggested that “the worst of the decline in manufacturing is behind us.” He cited unemployment and nonresidential construction as areas of the economy likely to remain weak in the months ahead. On inlfation, he said he gravitated towards those forecasters who place weight on inflation expectations, which had so far been well anchored.

However, Mr Lacker stressed the importance of not waiting too long before tightening policy and shrinking the Fed’s balance sheet. He also observed that when it came to tightening policy, the Fed would probably have to act to get bank reserves down “substantially from where they are now”. The Fed was also better able going forward to raise the effective fed funds rates since, from last October, it had the authority to pay interest on bank reserves.

Meanwhile, Kansas City President Hoenig expressed discomfort with some of the policies taken to fight the financial market crisis and stressed the importance of creating a systematic plan for addressing such issues in the future. He argued that the rush to respond to the crisis has had negative consequences including “inequitable outcomes among firms, creditor and investors that have increased uncertainty and undermined confidence.” This is particularly true for the “too big too fail” institutions. Hoenig outlined a plan to address this problem where firms that seek government assistance must put the taxpayer senior to all shareholders. Nonviable institutions would be allowed to fail, but in a systematic fashion in either a conservatorship or bridge institution where the bad assets would be liquidated and the firm could emerge stronger.

Mr Hoenig also addressed the longer-term consequences of the current policy response, including moral hazard. He argued that policymakers must credibly convince financial markets and institutions that the government is not setting a precedent of guarantees. In addition, Hoenig expressed concern about the rapid expansion of the Fed’s balance sheet, arguing that it will make it more difficult to remove the policy accommodation in the future. This, he argued, would subject the Fed to “new tests of its independence as a monetary authority.”