By Steven K. Beckner

(MNI) - Federal Reserve Governor Kevin Warsh issued a strong warning Friday that the Fed will invite trouble if it waits too long to tighten credit.

Warsh, expanding on preemptive monetary policy advice contained in a morning Wall Street Journal op-ed, told a Chicago Federal Reserve Bank conference that the Fed dare not wait until economic recovery is in full swing before beginning to tighten credit and that "greater swiftness" in credit tightening than usual is apt to be required when the time comes.

He said the Fed should tighten credit with a resolve equal to when it eased credit. He repeated his newspaper comment that the Fed may well need to tighten monetary policy before the need becomes "obvious" and that tightening may then need to be done "with greater force" than usual.

Warsh did not say when the Fed should start the policy firming process, but said economic and financial improvements suggest that the outlook and the odds of an "enduring positive feedback loop" are improving.

And he gave a clue on when the Fed is about to start unwinding its credit easing programs -- when the Fed decides that "unusual and exigent circumstances" in financial markets no longer exist.

Warsh, in remarks to an International Banking Conference at the Chicago Fed, also expressed consternation at changes in asset prices and yields which he called "difficult to reconcile" with historical patterns. He said such indicators will be important for policymakers to watch in the future.

Also important will be how non-monetary policies impact the economy's ability to grow, he said.

In his op-ed piece, Warsh had written, "I would hazard the view that prudent risk management indicates that policy likely will need to begin normalization before it is obvious that it is necessary, possibly with greater force than is customary, and taking proper account of the policies being instituted by other authorities," he said.

He went well beyond that comment in his speech, but first set the stage with comments on prospects for economic growth and inflation.

Warsh said policymakers need to ask some key questions:

-- "How is the economy currently performing relative to its long-run potential, and is this likely to change in the next few months?"

-- "Where is inflation now relative to its desired level, and what are the prospects for an acceleration or deceleration in prices in the near-term?

-- "Will changes in the federal funds rate interact with financial conditions and affect future real activity and inflation consistent with past practice?

-- "Or have these interactions changed, with implications for both the outlook and the conduct of policy?"

As have other Fed officials, Warsh suggested that inflation may be more of a threat than it now appears because the financial crisis may have reduced the economy's growth potential and in turn raised the natural or non-accelerating inflation rate of unemployment (NAIRU).

"It may be ... that potential output has fallen by virtue of the panic and its aftermath," he said. "If the resulting economy proves less adaptive, for example, the natural rate of unemployment may well threaten to move upward, implying tighter labor markets at higher unemployment rates, and lower potential output ... ." He acknowledged that productivity gains could work in the other direction.

Warsh said "data in the past couple of months show continued improvement in real economic performance. In combination with the repair in financial markets, the outlook for gross domestic product (GDP) in the next few quarters appears better, improving the odds of a more enduring positive feedback loop arising from market developments and real activity."

"Nonetheless, the medium-term risks to the outlook are still disquieting," he continued. "Policies, broadly defined, that purport to bring stability to the macroeconomy could risk lowering output potential over the horizon." He suggested that trade protectinism and increased regulation, for example, could pose "downside risks."

Failing to "accurately gauge the resulting changes in economic and inflation prospects ... is a foremost risk for policymakers," he said.

Posing a question of his own, Warsh asked, "When Will the Fed's extraordinary policy accommodation demand removal?"

While precise timing is "unknowable," Warsh said he believes that "if policymakers insist on waiting until the level of real activity has plainly and substantially returned to normal -- and the economy has returned to self-sustaining trend growth -- they will almost certainly have waited too long."

"A complication is the large volume of banking system reserves created by the nontraditional policy responses," he went on. "There is a risk, of much debated magnitude, that the unusually high level of reserves, along with substantial liquid assets of the banking system, could fuel an unanticipated, excessive surge in lending."

As he had written earlier, Warsh said "financial market developments bear especially careful watching" because "they may impart a more forward-looking sign of growth and inflation prospects than arithmetic readings of stimulus-induced GDP or lagged composite readings of inflation."

"If asset prices find a new and enduring equilibrium, market participants and policymakers alike may well gain additional comfort that the real economy is poised for sustainable recovery," he said. "However, if asset prices retrace their recent gains, the real economy would be adversely affected."

Warsh suggested recent increases in asset prices are brightening the economic outlook and, by implication, hastening the need for the Fed to remove its accommodation. "The broad and continued ascent in equities appears increasingly to reflect a new judgment about the modal outcome for economic growth and corporate earnings. If it turns out that equity risk premiums continue their recent trajectory, real economic performance would be bolstered further by sturdier household, business and financial firm balance sheets."

He confessed to being somewhat perplexed by the recent behavior of asset prices and yields. "In the past couple of months, U.S. stock market indexes and corporate bond prices both moved meaningfully higher, while Treasury yields and the foreign exchange value of the dollar fell. These movements are difficult to reconcile with historical experience or by ascribing them to changes in the modal growth path for the economy."

"Rather, this odd constellation of movements in asset prices may indicate changes in investor preferences and in the distributions of outlooks for inflation and growth," he continued, adding, "It would be more reassuring to growth and inflation prospects in the coming months if asset prices were to signal a clearer, more reliable message."

In further comments on how the Fed should respond to improving economic and financial conditions, Warsh said the "natural unwinding" of Fed penalty-rate lending programs "has proven largely successful," but noted that "the overall balance sheet size has remained relatively constant" because of offsetting asset purchases.

Noting that the Fed launched non-traditional lending programs under the Federal Reserve Act's section 13(3) authorization that it may lend to non-depository institutions under "unusual and exigent circumstances," Warsh said, "The judgment that the 13(3) standard is no longer satisfied would cause an unwinding of nontraditional policy tools by the Fed, and presage a normalization of policy."

Once the Fed decides to start "normalizing" policy, Warsh said "prudent risk management may prescribe that it be accomplished with greater swiftness than is modern central bank custom."

"If the economy were to turn up smartly and durably, policy might need to be unwound with the resolve equal to that in the accommodation phase," he said. "That is, the speed and force of the action ahead may bear some corresponding symmetry to the path that preceded it."

On the other hand, Warsh said that "if the economy remains mired in weak economic conditions, and inflation and inflation expectation measures are firmly anchored, then policy could remain highly accommodative."

** Market News International **