WRAPUP 2-Fed officials leery of unconventional policies

Fri Mar 26, 2010 7:29pm EDT

(Adds Tarullo remarks, market analyst comment)

By Pedro Nicolaci da Costa

WASHINGTON, March 26 (Reuters) - The Federal Reserve's unprecedented dose of stimulus to the economy during the recent financial crisis complicates the task of pulling back when the time is right, top central bank officials said on Friday.

Fed Board Governor Kevin Warsh argued that tame inflation readings today should not make policy makers complacent about the risk of future price increases.

"Inflation expectations will be anchored until they are not," Warsh said in a speech in New York. "Central bankers would be prudent to keep a very open mind about shocks that could happen domestically and overseas."

Ben Bernanke, the Fed chairman, told Congress on Thursday that the central bank is aware of such risks and has the tools necessary to withdraw monetary stimulus in time.

These include direct open market operations to drain reserves, raising the interest the Fed pays on excess bank reserves parked at the central bank, and outright sales of some of the nearly $1.5 trillion in mortgage-related assets the Fed committed to buying over the course of the crisis.

In an effort to combat the worst financial crisis in generations, the Fed not only slashed interest rates effectively to zero percent but also embarked on an unprecedented emergency program of asset purchases aimed at keeping borrowing costs low and cushioning the housing sector.

A small group within the Fed, mostly presidents of some regional Federal Reserve banks, has shown discomfort with this unorthodox policy, arguing it borders on fiscal policy and could make removing liquidity from the system difficult.

Charles Plosser, president of the Philadelphia Fed, said on Friday in an interview with The Wall Street Journal it might be prudent for the Fed to sell some of its mortgage assets before raising interest rates to make policy more effective.

In the past, Plosser has gone as far as suggesting the Fed should undertake a swap of mortgage assets with the Treasury Department so that its portfolio can return to being primarily composed of sovereign bonds rather than private debt.

"Given the market functioning, I don't anticipate that selling MBS at a reasonable pace is going to have a tremendous impact on mortgage rates," Plosser said.

HOUSING, GREECE WILDCARDS

But James Bullard, president of the St. Louis Fed who has also advocated asset sales as a potential early step in the Fed's exit, said recent weakness in housing data was giving him pause.

Sales of newly built U.S. homes fell for a fourth straight month in February to a record low annual rate of 308,000 units.

"It's making me nervous," he told Reuters on the sidelines of a conference sponsored by the Fed. "I will be interested in seeing the (upcoming) data, and if that begins to not look good, then I'll start to wonder."

Bullard said he does not foresee any sharp rebound in housing activity, adding that a stabilization in prices and sales would be enough of a signal that selling assets would not be too disruptive. He said the U.S. economy is on track for a reasonable recovery.

Market analysts appear convinced that asset sales will not be the Fed's preferred method for withdrawing stimulus.

"We believe a plan to sell Fed assets is still a long ways off," said Joseph Abate, money market strategist at Barclays Capital.

Asked about the crisis affecting Greece, whose heavy indebtedness has sparked widespread fears of renewed financial turmoil, Bullard was cautiously optimistic.

"So far I think we're OK. I wouldn't want to play it down too much," he said. "We played down other things too much during this crisis, and it came back to bite us. So, we're watching it very carefully. But right now I don't see it having any feedback to the U.S."

These actions have led to a sharp rise in Fed credit to the banking system, which some economists worry has the potential to ignite future inflation, or at the very least, complicate policy makers' task of removing monetary accommodation. Such outstanding reserve credit, often referred to as the Fed's balance sheet, now stands at a record $2.3 trillion.

"The Fed, as first responder, must strongly resist the temptation to be the ultimate rescuer," Warsh said.

At the Fed's conference, Bullard asked one economist presenting a paper, Columbia Professor Michael Woodford, whether he believed the central bank would have to drain reserves even as it raises interest rates in order for rates to respond.

Woodford argued that such operations were not strictly necessary. Those advocating them are being "excessively cautious," he said.

STRESS-TEST REGULATION

In separate remarks on Friday, Fed Board Governor Daniel Tarullo focused on regulation, his principal purview at the central bank.

He argued that public disclosure of bank stress test results last year helped rescue the global financial system, and regulators should weigh some level of transparency in future tests.

Congress is considering various versions of financial regulatory reform, some of which might reduce the Federal Reserve's role over policy. Many fault the Fed for loose oversight that allowed dubious practices in both banking and housing to thrive, leading to the financial crisis.

But Tarullo argued the Fed has reformed its ways, fine-tuning the way it supervises banks to include possible risks to the system as a whole, looking beyond the individual conditions of specific institutions.

As for releasing future stress test results, Tarullo cited pros and cons. One risk would be that fears about potentially troubled banks might be self-fulfilling. (Additional reporting by Emily Kaiser, Kristina Cooke and Steven C. Johnson; Editing by Kenneth Barry and Leslie Adler)

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