UPDATE 1-Fed's Bullard says asset purchases a potent tool

Mon Sep 26, 2011 10:14am EDT

(Adds more Bullard comments)

NEW YORK, Sept 26 (Reuters) - The U.S. Federal Reserve should decide on any future asset purchases on a meeting-by-meeting basis as they are "a potent tool" that must be used with care, a top Fed official said on Monday.

The Fed's balance sheet policy is the most effective tool for conducting monetary policy in a near zero-percent interest rate environment, St. Louis Fed President James Bullard told a panel at a conference hosted by Medley Global Advisors and the Financial Times.

Last week, the Fed increased its aid to the beleaguered economy, saying it would launch a $400 billion program to tilt its $2.85 trillion balance sheet more heavily to longer-term securities. The Fed said it would sell shorter-term notes and use those funds to purchase longer-dated Treasuries.

The Fed's second round of quantitative easing, or QE2, which ended in June "clearly drove both inflation and inflation expectations higher and closer to the committee's implicit target over the last year," he said.

That happened even as the U.S. economy was weaker than the Fed had expected last fall, he said, suggesting the gap between actual and potential growth might be smaller than previously thought.

"You shouldn't count all the run-up in the bubble as fundamental potential output," he said. Bullard said that while the recovery looks weak compared with 2007, "it is not reasonable to expect the economy to climb rapidly back to the 2007 Q4 peak since part of that peak was due to artificial growth driven by bubble behavior."

Bullard said the Fed's other main tool -- to promise near-zero rates for a specific time period -- has some potential drawbacks. He said it is not clear how credible such a promise can be and warned that pledging to policy easy for longer and longer periods might lead to markets expecting a mild rate of deflation.

The Fed has pledged to keep rates low for two years. (Reporting by Kristina Cooke; Editing by Padraic Cassidy & Theodore d'Afflisio)

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