Uncertainty over the outlook for inflation “is as high as it has ever been since 1980”, James Bullard, the president of the Federal Reserve Bank of St Louis, has told the Financial Times.

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The St Louis Fed president said he would not favour tightening policy before recovery was well-established. “You are going to need to have jobs growth and you are going to need to have unemployment declining.”

But once the recovery looked solid and there were consistent good monthly job gains, the Fed could “remove some of the accommodation”.

Mr Bullard said tightening “does not have to involve as its first step moving the federal funds rate off zero”.

Instead, he favoured at that point selling back assets bought by the Fed in the course of its unconventional easing.

Most Fed officials fear that asset sales would rock the markets and push up long-term interest rates, including mortgage rates. However, Mr Bullard said: “It seems perfectly reasonable to me.” He argued that, with proper planning, asset sales did not need to be disruptive.

Living with a bloated balance sheet for too long would risk fuelling inflation, he warned. “I am concerned that if, over a longer term, you just leave this many reserves in the system, under any ­normal theory . . . that is raw material for the money supply.”

[W]hile one can argue that by agreeing to purchase up to $300 billion in long-term U.S. Treasuries, the FOMC provided a needed short-term tonic to private credit markets, we dare not come to be viewed as a handmaiden to the Treasury. By loosening the anchor we have established for long-term inflation expectations, we could create the perception that monetary policy is subject to political imperatives, doing lasting damage to our ability to maintain price stability and restore full employment. I believe we have come as close as we dare to the line between acceptable and unacceptable risk in this regard, and do not personally wish for us to expand or extend our purchases of Treasuries beyond the cumulative $300 billion planned by this fall.

[W]hen the FOMC announced in March that the Fed would expand these purchases, interest rates declined on both Treasury securities and agency-backed MBS. Still, even though these programs appear to be having a useful effect, we have little experience with them and the magnitude of their impact is uncertain. In other words, it is difficult to tell if unconventional monetary policies will be as effective in promoting recovery as easing the funds rate has been in the past.

The second step toward strengthening the credibility of our commitment to sound monetary policy is to clarify the criteria under which we choose to step in as a lender of last resort. We must spell out when we will intervene in markets or extend unusual credit to firms — and then we must be willing to stick to those criteria. Moreover, we also need to complement such clear commitment with a well-articulated exit strategy from such liquidity or credit programs.

Our lending programs were created for extraordinary times and involve significant intervention in the private markets, but they run contrary to a long-standing and sound Fed practice of trying to minimize the effect of its actions on the allocation of credit across market segments. In my view, such programs are not, and should not, be part of the normal operation of a central bank.

One suggestion that would promote a clearer distinction between monetary policy and fiscal policy and help to safeguard the Fed's independence would be for the Fed and Treasury to reach an agreement whereby the Treasury takes the non-Treasury assets and non-discount window loans from the Fed's balance sheet in exchange for Treasury securities. Such an accord would offer a number of benefits.⁴ First, it would transfer funding for the credit programs to the Treasury — which would issue Treasury securities to fund the programs — thus ensuring that credit policies that place taxpayer funds at risk are under the oversight of the fiscal authority. Second, it would return control of the Fed's balance sheet to the Fed, so that we can continue to conduct independent monetary policy. Going forward, an agreement with Treasury would also state that if the fiscal authority at some point wanted the central bank to engage in lending outside its normal operations and, importantly, should the Fed determine "unusual and exigent circumstances" warranted such action, then any accumulation of nontraditional assets by the Fed would be exchanged for government securities.

Although the early attempts to staunch the recession were well-intentioned, it will be a subject of debate for some time on whether the rush to action might have contributed to the worsening of conditions.

[T]he BOJ's most recent financial statement showed that of the 68 percent of its assets held in the form of government securities, about two-thirds are long-term Japanese government bonds (JGBs)... If the Bank of Japan were to succeed in replacing deflation with a low but positive rate of inflation, its reward would likely be substantial capital losses in the value of its government bond holdings arising from the resulting increase in long-term nominal interest rates.

With such concerns in mind, BOJ officials have said that a strengthening of the Bank's capital base is needed to allow it to pursue more aggressive monetary policy easing. In fact, the BOJ recently requested that it be allowed to retain 15 percent (rather than 5 percent) of the surplus for the 2002 fiscal year that just ended to increase its capital, and the Ministry of Finance has indicated that it will approve the request. Even with this additional cushion, however, concerns on the part of the BOJ about its balance sheet are likely to remain.

The public debate over the BOJ's capital should not distract us from the underlying economics of the situation... Indeed, putting aside psychological and symbolic reasons, important as these may be in some circumstances, there appear to be only two conceivable effects of the BOJ's balance sheet position on its ability to conduct normal operations. First, if the BOJ's income were too low to support its current expenditure budget, the Bank might be forced to ask the MOF for supplemental funds, which the BOJ might fear would put its independence at risk... Second, an imaginable, though quite unlikely, possibility is that the Bank could suffer sufficient capital losses on its assets to make it unable to conduct open-market sales of securities on a scale large enough to meet its monetary policy objectives.

In short, one could make an economic case that the balance sheet of the central bank should be of marginal relevance at best to the determination of monetary policy. Rather than engage in what would probably be a heated and unproductive debate over the issue, however, I would propose instead that the Japanese government just fix the problem... I am intrigued by a simple proposal that I understand has been suggested by the Japanese Business Federation, the Nippon Keidanren. Under this proposal the Ministry of Finance would convert the fixed interest rates of the Japanese government bonds held by the Bank of Japan into floating interest rates. This "bond conversion"--actually, a fixed-floating interest rate swap--would protect the capital position of the Bank of Japan from increases in long-term interest rates and remove much of the balance sheet risk associated with open-market operations in government securities.