I was uncomfortable with QE3, the program whereby we committed to a sustained purchase of $85 billion per month of longer-term U.S. Treasury bonds and mortgage-backed securities (MBS). I considered QE3 to be overkill at the time, as our balance sheet had already expanded from $900 billion to $2 trillion by the time we launched it, and financial markets had begun to lift off their bottom. I said so publicly and I argued accordingly in the inner temple of the Fed, the Federal Open Market Committee (FOMC), where we determine monetary policy for the nation. I lost that argument. My learned colleagues felt the need to buy protection from what they feared was a risk of deflation and a further downturn in the economy. I accepted as a consolation prize the agreement, finally reached last December, to taper in graduated steps our large-scale asset purchases of Treasuries and MBS from $85 billion a month to zero this coming October. I said so publicly at the very beginning of this year in my capacity as a voting member of the FOMC. As we have been proceeding along these lines, I have not felt the compulsion to say much, or cast a dissenting vote.

However, given the rapidly improving employment picture, developments on the inflationary front, and my own background as a banker and investment and hedge fund manager, I am finding myself increasingly at odds with some of my respected colleagues at the policy table of the Federal Reserve as well as with the thinking of many notable economists.

[W]ith low interest rates and abundant availability of credit in the nondepository market, the bond markets and other trading markets have spawned an abundance of speculative activity. There is no greater gift to a financial market operatoror anyone, for that matterthan free and abundant money. It reduces the cost of taking risk. But it also burns a hole in the proverbial pocket. It enhances the appeal of things that might not otherwise look so comely. I have likened the effect to that of strapping on what students here at USC and campuses elsewhere call beer goggles. This phenomenon occurs when alcohol renders alluring what might otherwise appear less clever or attractive. And this is, indeed, what has happened to stocks and bonds and other financial investments as a result of the free-flowing liquidity we at the Fed have poured down the throat of the economy.

These lending operations changed the composition of the Fed's asset portfolio without changing the Fed's monetary liabilities, and thus constituted "credit policy," not monetary policy.4 Such lending raises important issues related to the independence of central banks and their role in the financial system.5 I have spoken at length about these issues on other occasions, but they are not my focus today.6

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When a central bank uses its independent balance sheet to choose among private sector assets, it invites special pleading from interest groups and risks entanglement in distributional politics. Similar political risks face a central bank, such as the European Central Bank, allocating investments across multiple sovereign debt issuers.

Political pressure to channel credit to favored sectors is not without precedent in the United States. Congress gave the Fed authority to buy the debt of U.S. agencies such as the housing government-sponsored enterprises in 1966 in response to the "credit crunch" that year that reduced flows to housing finance… In 1971, the FOMC relented and began outright purchases of the debt of the housing government-sponsored enterprises.12 (By 1981, purchases had stopped, and the Fed's holdings ran off gradually over the 1980s and 1990s. Outright purchases of agency securities were not conducted again until early 2009.)

How central banks manage the political risks associated with forays into credit policy may prove pivotal for the evolution of central banking in advanced economies. A central bank's core responsibility revolves around its liabilities — that is, the monetary assets it uniquely supplies. Being organized as distinct, off-budget intermediaries, however, requires them to hold assets, and just what assets the central bank should hold has been something of a conundrum…

Of the risks associated with unconventional monetary policies, those associated with central bank holdings of unconventional asset classes may be the most consequential. Violating the implied truce under which central banks avoid credit policy has the capacity to perturb the delicate governance equilibrium supporting the independent conduct of monetary policy. History provides numerous examples of compromised central bank independence leading to calamitous monetary policy.

“My personal predilection would be to get out of the MBS market as soon as possible,” Lacker said to reporters. “I think the housing finance market can easily withstand a substantial liquidation of our MBS holdings.”

[The Fed] “opened the floodgates” and “it worked,” the regional bank chief, who votes on monetary policy this year, said during a speech today in Dallas. “We re- liquefied the economy. In my opinion, we might have done too much."

Of course, those who worry about the inflationary consequences of our balance sheet may be looking to the future. As the economy improves, banks may use their reserves to rapidly expand business lending – increasing economic activity and putting upward pressure on inflation.  But as Chairman Bernanke has emphasized, the Federal Reserve has at its disposal a variety of tools that will allow it to remove reserves from the banking system once economic conditions get closer to normal. Thus the fear that our large balance sheet and the large stock of reserves in the banking system will cause inflation – either now or down the road – seems misplaced to me.

I would just like to keep [the agency bond and MBS purchase programs] active at a very low level instead of saying we’re shutting down, shutting down permanently. Initially it would do nothing for the economy, but it would give the Fed the option to react to future news as it comes in... If the economy came in very weak, let’s say, in 2010, weaker than expected, we would have the option of doing further quantitative easing.  If the economy came in stronger than expected and inflation expectations started to ratchet up a little bit we could maybe sell off some of these assets and remove some of the accommodation from our quantitative easing program.

[U]se of Fed liquidity facilities has declined sharply since the beginning of the year--a clear market signal that liquidity pressures are easing and market conditions are normalizing.

Aggressive policy actions taken around the world last fall may well have averted the collapse of the global financial system, an event that would have had extremely adverse and protracted consequences for the world economy.

[T]he objective of liquidity programs is to facilitate the intermediation of credit to households and businesses. The immediate goal of such facilities, however, is the reduction of stresses in the interbank funding market. The significant narrowing since the start of this year in important measures of stress in this market--specifically, Libor-OIS spreads, shown in the left panel of figure 2--together with diminished usage of these facilities--shown to the right--suggest that some easing in this market has occurred in line with the implementation and expansion of these initiatives.

Taken as a whole, our nontraditional policies might look like a vast array of acronyms—the famous "alphabet soup" (TSLF, PDCF, etc.). But there is a method to the madness, and I will highlight three precepts that guide our thinking. The first is insurance: Don't put all your eggs in one acronym. The second is innovation: This is not your grandfather's Fed. And the third is size: In an environment of great uncertainty, as we like to say in Chicago, "make no little plans."

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Rather than rely on any single tool lest it prove inadequate, we have put in place a number of different remedies in quick succession, in the hope that we may learn which ones work best without losing valuable time.

Only that I respectfully disagree with her views. The U.S. and global economies, including Germany, have faced an extraordinary combination of a financial crisis, not -- unlike any seen since the Great Depression, plus a very serious downturn.

And in that context, I think strong action on both the fiscal and monetary sides is justified to try to avoid an even more severe outcome.

In response to a question about Angela Merkel's criticism of the expansion of the Fed and BOE balance sheets.

Looking ahead, prognosticators this year have divided into several different camps. Some believe that high unemployment necessarily will lead to continually falling inflation for several years, and they are concerned about the risk of outright deflation. I personally have thought the risk of deflation was overstated, and for the first three months of this year, inflation has averaged 2 ¼ percent – both core prices and overall prices. Another camp places significant weight on the public’s expectations, and as near as we can figure, those are fairly well anchored around 2 percent. And finally, a third camp sees the rapid growth in our balance sheet, notes the historical association between rapid money growth and subsequent inflation, and wonders whether inflation will accelerate when the economy begins to recover.

Where do I stand? While I gravitate to the second camp – the one that views stable expectations as likely to anchor inflation in the near term – members of the third camp have identified inflation risks that are quite legitimate. The challenge for us on the Federal Open Market Committee will be to shrink our balance sheet and tighten policy soon enough when the recovery emerges to prevent rising inflation. The danger is that we will not shrink our balance sheet and tighten policy soon enough when the recovery emerges to prevent rising inflation. Choosing the right time to withdraw that stimulus will be a challenge, and I believe it will be very important to avoid the risks of waiting too long or moving too slowly.

As I see it, there are four major reasons behind the dramatic expansion of the Fed’s liquidity programs:

1. To provide liquidity to banks and dealers in order to slow down the deleveraging process.
2. To expand the balance sheet capacity of the private sector to counteract the shrinkage underway in the non-bank financial sector.
3. To restore and improve market function.
4. To ease financial market conditions.

Lenders have been concerned about counterparty risk and about conserving their own capital against unforeseeable events. We can't deal with those concerns through our lending because we do not take appreciable credit risk. But confidence about access to funding has been a part of the problem, as reflected in the evaporation of trading in term maturities in a wide range of wholesale funding markets and the elevated spreads paid by even very safe borrowers. The limited availability of credit to sound borrowers, even when secured by what had been seen as good collateral, has been a source of instability and constraint on credit flows. Central banks can address such a shortage because they can remain unaffected by panicky flights to liquidity and safety. Their willingness to extend collateralized lending in size against a broad range of assets can replace flows of private credit that are normally uncollateralized.

Another concern that I hear expressed with increasing frequency is that the huge expansion of Fed lending will trigger a surge in inflation. The worry seems to be that the Fed has financed its credit programs by increasing the excess reserves of commercial banks, and these reserves could eventually fuel an inflationary surge...

With regard to inflation, I think fears that inflation will jump once the economy begins to recover are overdone for several reasons. First, and most important, the Fed is fully committed to maintaining price stability within its dual mandate...