Friday, 31 Aug 2012 07:58 AM

By Forrest Jones

A combination of loose monetary policies and stubbornly high unemployment rates could raise the risk that inflation could strike the economy down the road, says Harvard economist Martin Feldstein.

Since the downturn, the Federal Reserve has sought to spur the economy by buying assets like Treasury holdings or mortgage-backed securities held by banks, a monetary stimulus tool known as quantitative easing that pumps vast amounts of liquidity into the financial system.

Banks are awash with that money and many are keeping it stashed in Federal Reserve accounts for now, but when the economy improves, lending will ultimately rise.

Once lending gets to the point that inflation might pose a threat, the Fed could raise the interest rate is applies to bank reserves, causing banks to pull back and stash more money at the Fed.

The problem, Feldstein points out in a Project Syndicate column, lies in stubbornly high unemployment rates.

Many Americans have been out of work for so long that employers feel their skills are out of date, and those workers will be the among last to get hired when the economy improves, he notes.

That will take a long time to happen, and inflationary pressures will likely be increasing before Congress is happy with the number of Americans back at work.

The Fed adheres to a dual mandate set by Congress of keeping prices stable and employment rates optimal.

Since the Fed is accountable to Congress and reports to it every year, it might feel pressured to keep deposit rates and other lending metrics accommodative until enough unemployed Americans are back at work, with the result being inflation already a reality by then.

“If that happens, Fed officials will face a difficult choice: tighten monetary policy to stem accelerating price growth, thereby antagonizing Congress and possibly facing restrictions that make it difficult to fight inflation in the future; or do nothing. Either choice could mean a higher future rate of inflation, just as financial markets fear,” Feldstein writes.

Similar measures could play out in Europe, even though the European Central Bank adheres to only one mandate — to keep prices stable.

“Although the ECB does not have to deal with direct legislative oversight, it is now clear that there are members of its governing board who would oppose higher interest rates, and that there is political pressure from government leaders and finance ministers to keep rates low,” he adds.

“Rising inflation is certainly not inevitable, but, in both the U.S. and Europe, it has become a risk to be reckoned with.”

Federal Reserve officials have said they cannot rule out fresh stimulus measures should the economy show signs of further waning, which would pump even more liquidity into the economy.

Some Fed officials have said the time has come for an open-ended round of easing, meaning the Fed should intervene for as long as it takes and not announce a fixed amount of assets it plans to purchase, as was the case with previous rounds or quantitative easing.

Without such accommodative monetary policy, unemployment rates will hover around current levels of 8.3 percent, says Chicago Federal Reserve Bank President Charles Evans.

“I don’t think we should be in a mode where we are waiting to see what the next few data releases bring,” Evans told a seminar at the Hong Kong Bankers Club recently, according to Reuters.

“We are well past the threshold for additional action; we should take that action now.”

Meanwhile, weekly initial jobless claims were unchanged at 374,000 in the week ended Aug. 25, according to the Department of Labor.

A sharp fiscal adjustment looms at the end of the year, which is prompting companies to put off investing and hiring.

At the end of the year, tax breaks are set to expire, including the Bush-era tax cuts while automatic cuts to public spending kick in at the same time, a combination known as a fiscal cliff that could send the country sliding into recession next year if left unchecked by Congress.

“In the next four months the economy is going to face some headwinds,” Thomas Simons, money market economist at Jefferies & Co. Inc. in New York, told Bloomberg.

“We’re stuck in this low-growth trajectory.”

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