UPDATE 1-Fed's Dudley ties bond buying to impact of US fiscal policy
By Jonathan Spicer
NEW YORK May 21 (Reuters) - The U.S. economy's ability in coming months to weather lower government spending and higher taxes will be key to the Federal Reserve's decision whether to reduce monetary accommodation, an influential Fed official said on Tuesday.
In a speech that could dampen some expectations of an early reduction in the U.S. central bank's bond buying program, New York Fed President William Dudley said he cannot at this point be sure whether policymakers will next reduce or increase the amount of purchases, due to the "uncertain" economic outlook.
"But at some point, I expect to see sufficient evidence to make me more confident about the prospect for substantial improvement in the labor market outlook," Dudley told the Japan Society in New York.
"At that time, in my view, it will be appropriate to reduce the pace at which we are adding accommodation through asset purchases," said Dudley, a close ally of Fed Chairman Bernanke and who has a permanent vote on Fed policy.
"Over the coming months, how well the economy fights its way through the significant fiscal drag currently in force will be an important aspect of this judgment."
The central bank is buying $85 billion in Treasury and mortgage bonds each month in an effort to encourage investment, hiring and economic growth in part because the unemployment rate remains high at 7.5 percent.
Yet with joblessness down from 8.1 percent in August, just before the latest round of quantitative easing (QE3) was launched, investors are anxiously predicting when the bond-buying will be reduced or halted.
Echoing past comments by both himself and Bernanke, who will give congressional testimony on Wednesday, Dudley said the Fed might adjust the pace of bond purchases as the outlooks for inflation and the labor market change "in a material way."
However he warned that investors could overreact to the first adjustment in the pace of asset purchases, making clear communication from the central bank all the more important.
The Fed's easy-money policy, including a promise to keep interest rates near zero until unemployment falls to 6.5 percent or so, has boosted bonds and stocks and any change to the policy could shake markets.
It has also raised concerns that the central bank's swelling balance sheet, now at some $3.3 trillion, will disrupt markets, stoke inflation, or cause the Fed to absorb losses when the time finally comes to reduce it to a more normal size around $1 trillion.
Dudley said the Fed's policy-setting committee could adjust its two-year old plan for reducing the balance sheet in the years ahead, calling parts of it "stale."
"To the extent that the committee wants to reduce the risk of disrupting market functioning during normalization, it could decide to indicate that it will avoid selling the MBS (mortgage-backed securities) portfolio during the early stages of the normalization process," he said.
"Moreover, to the extent that the committee wants to mitigate the risk of a sharp increase in long-term rates, it could judge that it would prefer not to commit to agency MBS sales."
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