Bullard: Fed will act if economy weakens further

President and CEO of the Federal Reserve Bank of St. Louis James Bullard gestures during an interview at the Federal Reserve Bank of St. Louis June 8, 2011.

(Reuters) - The Federal Reserve will act if the economy weakens further and has the tools to do so, a top Fed official said on Friday.

St. Louis Fed President James Bullard said he expects the economy to grow modestly over the next year -- though the sluggish pace leaves it vulnerable to shocks.

"Should economic performance deteriorate, monetary policy will respond," Bullard said, according to slides of a presentation he was scheduled to make . "The Fed is not now, or ever, 'out of ammunition'."

With interest rates near zero, Bullard said, the Fed can support the economy through inflation and inflation expectations and asset purchases are a "potent tool".

Dealers polled by Reuters earlier this month gave a median chance of 32 percent that the Fed will embark on a third round of quantitative easing.

The Fed said last week it plans to buy $400 billion of longer-term Treasuries and sell the same amount of shorter-term Treasuries by the end of June 2012, in an effort to lower longer-term borrowing costs.

It also said it would support the mortgage market by reinvesting principal payments from its mortgage-related debt into mortgage-backed securities.

Bullard said policy should aim to be more rules-based than it has been since the crisis hit and return to a meeting-by-meeting approach by the Federal Open Market Committee.

"The policy approach over the last several years, with announcements of large dollar amounts, fixed end dates, and rapidly changing tactics, seems fairly discretionary," he said.

"Returning to a more rules-based approach may provide needed stability to the U.S. macroeconomy."

Bullard repeated his view that promising to keep rates low for a specific period of time has a number of drawbacks, including the possibility of its hurting Fed credibility.

He also warned against tying monetary policy to the unemployment rate, as Chicago Fed President Charles Evans has suggested.

Unemployment rates have a "checkered history" in advanced economies over the last several decades, he said. In Europe over the last 30 years, for example, the unemployment rose and stayed high.

"If such an outcome happened in the U.S. and monetary policy was explicitly tied to unemployment outcomes, monetary policy could be pulled off course for a generation."

(Reporting by Kristina Cooke in New York, Editing by Chizu Nomiyama)