Fed's Lockhart says "some time" before Fed exit

By Alister Bull

NASHVILLE (Reuters) - The U.S. central bank will unwind its dramatic monetary expansion when the time is right, but that exit is not imminent even though slow growth should resume in the second half of this year, a top Federal Reserve official said on Monday.

"The Fed has a number of tools being readied to unwind the policies used to fight the recession, and it will be some time before their use is appropriate," said Dennis Lockhart, president of the Atlanta Federal Reserve Bank.

Lockhart, in a speech to the Rotary Club of Nashville, Tennessee, said the economy appears to be stabilizing. He also downplayed the threat of inflation as a result of the Fed's low interest-rate policy and other measures designed to stimulate the economy.

"Current economic conditions are mixed at best, but the economy appears to be in stabilization mode," he said. "Stabilization necessarily precedes recovery. A recovery has not yet taken hold, but should begin before too long."

In this environment, Lockhart said the risks of inflation and deflation were roughly balanced, adding he would challenge critics who argue the dramatic expansion of the Fed's balance sheet mean that money-supply-fueled inflation is imminent.

"Slack in the economy will suppress inflation. And inflation is unlikely to result -- by direct causation -- from the recent growth of the Fed's balance sheet," Lockhart said.

The Fed has cut interest rates to almost zero and doubled the size of its balance sheet to around $2 trillion.

Lockhart said the ability of the Fed to pay interest on excess reserves held with the U.S. central bank, granted by Congress during the crisis, would inhibit the transmission of this additional liquidity into higher prices.

"One should not assume at this point that extraordinary measures to shrink the balance sheet are required to contain inflationary pressures," Lockhart said. "Some inflation pessimists are not giving weight to the changed mechanics of monetary policy transmission to the broad economy."

As interest rates neared zero, the Fed switched to unconventional measures to stimulate economic activity by purchasing up to $1.45 trillion of mortgage-related debt and $300 billion of longer dated U.S. government bonds.

The U.S. central bank opted to not alter the scale of the program at its policy meeting last month. But Lockhart said that he felt the buying had helped economic conditions, and he did not rule out making adjustments in the future, if warranted.

"I am going to keep an open mind on that subject. It will depend on the overall conditions at the time, whether we think that ... more Treasury purchases would be helpful," he told reporters after the speech. "That may mean extending the program in terms of quantity of purchases as well as timeframe."

In the minutes of its June meeting, released last week, the Fed said that it decided not to increase Treasury purchases in part because of uncertainty over what this would do to perceptions of inflation and whether the Fed was 'monetizing' the debt to help fund a record U.S. budget deficit.

This had led to a sharp steepening in the yield curve in the weeks before the meeting, although this had been somewhat unwound by the time policymakers gathered.

Lockhart said that the decision to buy Treasuries had not been about driving long-term yields to a specific point, but rather was aimed at improving overall credit conditions.

"I think the purchases influenced interest rates and therefore the program, as it has rolled out, in probability had some positive effect on interest rates during the period," he said.