The global credit crisis creates big downside risks to an already softening economy that require bold action from the U.S. central bank, Cleveland Federal Reserve President Sandra Pianalto said on Wednesday.
U.S. economic growth essentially stalled in the fourth quarter as Americans grappled with the worst housing slump since the Great Depression and the banking sector reeled from a severe tightening of credit.
Under these circumstances, the Fed should err on the side of doing too much, despite signs of rising inflation, Pianalto said.
"Because credit contractions can emerge and spread rather quickly, the central bank must be prepared to act in an aggressive and timely manner to counteract their effects," Pianalto told an audience of investors at a New York event sponsored by the Money Marketeers.
Already, the central bank has slashed its benchmark federal funds rate by 2.25 percent since September to its current 3 percent, and it is widely expected to reduce rates again at its meeting later this months.
This is not to say the Fed has abandoned its key mandate of keeping price growth in check, Pianalto added, but simply that weakening economic conditions should stem price pressures over the next few years.
Pianalto said it was important to keep inflation expectations in line, noting that these were often difficult to measure. However, she seemed confident that prices would stabilize, presuming commodity and energy prices stopped their recent acceleration.
Of course, this is a tough assumption to make in a week that saw oil prices reach record highs above $104 a barrel, but Pianalto said she was reassured by the evidence to date.
"Inflation expectations appear to be anchored," she said.
Because of the extraordinary uncertainty associated with deteriorating credit conditions, the Fed should be willing to continue taking action, both in the form of easier monetary policy and continued efforts to ensure liquidity.
"Both the academic literature and our limited experience suggest that the real rate of interest that is consistent with a neutral monetary policy will decline during a credit crunch, and that the nominal federal funds rate target needs to adjust accordingly to keep policy from becoming unduly restrictive," Pianalto said.