October 4, 2010 / 3:42 PM / 7 years ago

Fed's Sack: more bond purchases would help economy

NEW YORK (Reuters) - Further asset buying by the Federal Reserve would help spur the economic recovery, and a small-step approach would enable the U.S. central bank to be more responsive to evolving conditions, the head of the New York Fed's markets group said on Monday.

Brian Sack told a conference in Newport Beach, California that whether the Fed's policy-setting committee decides to do more to support the economy depends on how policymakers view the costs and benefits of further asset buys.

But Sack, who briefs the Fed's policy-setting committee on market conditions, said in his view the arguments that further purchases won't affect the economy were "overstated".

"It is true that certain aspects of the transmission mechanism are clogged because of the credit constraints facing some households and businesses, and it is true that monetary policy cannot directly target those parties that are the most constrained," he said, according to prepared remarks.

But, he added, further purchases could still lower borrowing costs for households and businesses.

"It seems highly unlikely that the economy is completely insensitive to borrowing costs and wealth, or to other changes in broad financial conditions," he said.

The Fed's policy-setting committee said in September that it is prepared to further ease monetary policy if needed. The Fed has already cut its benchmark interest rate to near zero and bought $1.7 trillion of mortgage-related and Treasury bonds. Many analysts believe the Fed will embark upon another round of asset buying by year-end to spur a slow recovery.

"The evolution of the balance sheet going forward will depend on how the economic outlook unfolds," Sack said.

"The anticipated recovery is relatively tepid and thus delivers only slow progress toward meeting the Federal Reserve's dual mandate" of full employment and price stability.

Sack, whose group is charged with implementing the Fed's policy directives, discussed how another asset purchase program could be designed.

He said if the Fed took a smaller-step approach to purchases it would bear more similarity to the way the Fed has historically changed its benchmark federal funds rate.

In the first round, the Fed took a "shock and awe" approach to purchases, announcing its $1.7 trillion in purchases in two big steps.

"That (approach) might have been appropriate in circumstances when substantial and front-loaded policy surprises had benefits, but different approaches may be warranted in other circumstances," he said.

A small-step, open-ended approach would also give the Fed more flexibility, he said.

"If changes in the balance sheet are now acting as a substitute for changes in the federal funds rate, then one might expect balance sheet decisions to also be governed to a large extent by the evolution of the FOMC's economic forecasts," he said.

As the Fed is learning as it is going about the costs and benefits of purchases, smaller steps would give it more discretion to change course as needed, he said.

Addressing some of the potential operational costs, Sack said it seems the Fed could expand its Treasury securities holdings without creating market distortions.

He said the Fed's system open market account currently holds about 12 percent of the outstanding stock of Treasury coupon securities. There will also be plenty of supply, he said, with the Treasury expected to issue around $1.2 trillion over the next year.

If mortgage-backed securities cheapened significantly relative to Treasuries, this could affect the Fed's decision on what assets to buy, he said.

Sack added that he was not worried that a bigger balance sheet will further complicate the Fed's eventual exit from its accommodative policies.

"I am confident that our ability to exit will not be compromised by any further expansion of the balance sheet," he said.

Editing by James Dalgleish

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