UPDATE 1-Fed's George says hopes U.S. bond buying can be reduced

Fri May 10, 2013 5:13pm EDT

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JACKSON, Wyo. May 10 (Reuters) - The Federal Reserve should scale back U.S. bond purchases to reduce the risks of continuing to expand its balance sheet, a senior central banker said on Friday, noting that the Fed's last statement explicitly stated it could vary the pace of buying.

Kansas City Fed President Esther George, who has been the sole dissenting vote against the policy at every meeting this year, acknowledged that the markets paid most attention to the prospect of the Fed boosting the pace of purchases.

"But the statement also allows for decreases," she told the Wyoming Business Alliance during a luncheon speech. "So it is my hope, as my colleagues and I continue to discuss these issues and consider what is happening in the economy, that that opportunity will be there and we can begin to make this exit."

The Fed on May 1 voted to keep buying bonds at a monthly pace of $85 billion, but tweaked the statement announcing this decision to spell out it was "prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation."

Fed officials, including Chairman Ben Bernanke, had stated this on previous occasions, but inserting it into the statement gave it greater weight in the eyes of Fed-watchers.

Recent mixed signals on the U.S. economy, and particularly a decline in a measure of inflation which the Fed watches closely, had led to speculation the U.S. central bank might be ready to buy even more bonds as extra insurance to keep the recovery on track.

U.S. growth picked up to 2.5 percent in the first quarter at an annual rate, from 0.4 percent in the previous three months, and added an unexpectedly solid 165,000 new jobs in April while unemployment edged down from a still-lofty 7.5 percent.

Inflation, however, which the Fed aims to keep near 2 percent, is only half that pace on its preferred gauge, the PCE price index. Some warn this is dangerously low and could risk a damaging deflationary spiral if the economy weakened, though market-based measures of future inflation have remained well above 2 percent.

George was wrapping up a tour of local businesses and communities in Wyoming, a state which has benefited from robust energy markets, which dominate industry in the region.

FISCAL DRAG

She said she expects U.S. growth to run around 2 percent for the year, and noted that job creation had averaged 200,000 per month over the last six months, a level which would begin to reduce slack in U.S. labor markets.

Growth had faced a headwind, notably from tax hikes and automatic cuts in government spending inflicted because of the failure of lawmakers in Washington to agree on steps to reduce the deficit. But this fiscal drag will be felt mainly in the second and third quarters, she said, and will then begin to fade.

The Fed has held interest rates near zero since late 2008 and bought around $2.7 trillion worth of bonds and has vowed to keep rates ultra-low until the jobless rate reaches 6.5 percent, so long as the outlook for inflation stays under 2.5 percent.

George, one of the Fed's more hawkish officials, also said she favored taping bond purchases because she worried that continuing to expand the balance sheet could cause future financial instability and quickening inflation.

In particular, the prolonged period of near-zero U.S. rates has already caused investors to "reach for yield," exposing them to significant risk when rates begin to rise as the Fed starts to exit.

As a result, U.S. policymakers must make a very careful policy transition to avoid spooking markets, and George made plain that she viewed this as a tricky challenge to successfully pull off.

"My concern is we do that in a fashion that does not create sharp increases in rates, backing up mortgage rates, when we announce that we're going to stop bond purchases (or) we are going to adjust those in some way."

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