Purchases may increase nominal gross domestic product as much as $1 trillion “over the next several years,”

TO BE NOTED: From Bloomberg:

"Kohn Says Fed Asset Purchases May Boost Economy by $1 Trillion

By Scott Lanman

May 24 (Bloomberg) -- Federal Reserve Board Vice Chairman Donald Kohn said the U.S. economy may get a $1 trillion boost in coming years from the central bank’s purchases of government and mortgage debt, along with $175 billion in extra tax revenue.

Kohn defended the central bank’s response to the financial crisis and worst recession in 50 years while saying the central bank “needs a framework” for tightening credit when the economy rebounds. Some economists and Fed officials, including Philadelphia Fed President Charles Plosser, say adding the assets to the balance sheet risks spurring inflation.

“The preliminary evidence suggests that our program so far has worked,” Kohn, 66, said yesterday in a speech during a panel discussion at a conference on monetary and fiscal policy at Princeton University in New Jersey. He cited reductions in longer-term interest rates.

The Fed is in the process of buying $300 billion of long- term Treasuries through September, as authorized at the March meeting of the Federal Open Market Committee. Policy makers also at the time more than doubled planned purchases of mortgage- backed securities to $1.25 trillion this year and boosted federal agency debt purchases to $200 billion from $100 billion.

The comments make it more likely that Fed officials will “extend or expand” programs to purchase the assets, Michael Feroli, a JPMorgan Chase & Co. economist and former Fed researcher, said in a note yesterday.

Purchases may increase nominal gross domestic product as much as $1 trillion “over the next several years,” Kohn said in a footnote to his remarks.

Fire Sales

Other Fed interventions to aid bond dealers, mutual funds and credit markets also “have been successful in supporting economic growth” by lowering rates and “preventing fire sales of assets,” Kohn said.

Kohn, in his speech, said he’s “very much looking forward to” having the central bank “return to more normal modes of operation” as the economy rebounds.

While the purchases expose the Fed and taxpayers to potential losses, Kohn said several considerations make such an outcome unlikely. The Fed won’t need to sell some of the Treasury and agency debt because it will mature, and the central bank can fund the purchases at low cost. Also, the purchases boost the economy and tax receipts, he said.

Still, Kohn said “any calculation of the effect of our asset purchases on the economy is highly uncertain.”

U.S. nominal GDP fell to $14.1 trillion on an annual basis in the first quarter from $14.2 trillion in the prior three months and $14.4 trillion in the third quarter of 2008. It was the first back-to-back decline since 1958.

‘Believable’ Impact

Alan Blinder, a former Fed vice chairman who is a Princeton economics professor, said Kohn’s estimate of the effect on GDP from the mortgage-bond purchases is “believable.”

“It was supposed to reduce the risk spread between mortgage rates and other rates, and I think it has,” Blinder said in an interview. “You get these multiplier effects” on the economy from spending on housing, said Blinder, a panelist with Kohn at the conference.

Blinder said he’s “more dubious” about the Treasury purchases themselves. Any reduction in long-term rates makes it more difficult for U.S. banks to generate earnings to make up for what the Fed estimated earlier this month would be $600 billion in losses under adverse economic conditions. “It makes it harder for them to earn their way out,” he said.

Kohn reiterated his view that the U.S. economy “is only now beginning to show signs that it might be stabilizing, and the upturn, when it begins, is likely to be gradual amid the balance sheet repair of financial intermediaries and households.”

More Power

Kohn said closer cooperation between the Fed and “fiscal authorities” is an “inevitable aspect of effective policy initiatives to meet our macroeconomic objectives in the current financial and economic crises.” He reiterated that the central bank is working with the Obama administration to seek additional powers for the Fed to tighten credit.

Plosser, by contrast, said in a May 21 speech that “when a nation’s treasury or finance ministry and its central bank work too closely together, there is a clear risk that the government’s spending will end up being financed by the central bank’s power to create money and that the public will become confused as to their respective roles.”

“History shows us that you can get very bad economic outcomes with rapidly rising inflation,” said Plosser, 60, the Philadelphia Fed’s president since 2006.

Political Pressures

Central banks do “need a degree of insulation from short- term political pressures” to do their job of keeping prices stable and employment high, Kohn said.

Speaking during an audience discussion before his speech, Kohn said the central bank’s power to pay interest on banks’ deposits will do a better job of keeping the benchmark rate at the desired level as financial markets improve.

“It hasn’t been a totally effective floor,” he said. “As the balance sheet shrinks and as banks become better capitalized, that will become an effective floor.”

To contact the reporter on this story: Scott Lanman in Princeton, New Jersey, at slanman@bloomberg.net."