SAN FRANCISCO (Reuters) - Offering one of the clearest road maps yet for the Federal Reserve's latest monetary stimulus, John Williams, a top Fed policy maker, said on Monday he expects the central bank to expand its bond-buying program next year and end it before the close of 2014.
Williams, president of the San Francisco Fed, said that because it will take more than a few months for the U.S. central bank's latest round of bond-buying to drive down the high unemployment rate, there is good cause to ratchet up the Fed's already aggressive measures.
The Fed began buying $40 billion a month in mortgage-backed securities this month and has pledged to continue the purchases until the labor market has improved substantially. The program is called QE3 because it is the Fed's third try at quantitative easing, or buying bonds to stimulate the economy.
The Fed is also buying $45 billion in long-term Treasuries each month and selling a like amount of short-term Treasuries in a program known as Operation Twist, which is also designed to lower long-term borrowing costs, such as mortgages. Twist is set to expire at the end of the year.
Because unemployment will likely have budged little from its current 8.1 percent level by that time, Williams said, "a strong case could be made" for continuing the current level of mortgage-backed securities purchases and expanding into Treasuries purchases once Twist expires.
What QE3 should do, he said, is push down borrowing costs, making the purchase of new cars cheaper, for example, which in turn will boost sales and, eventually, prompt factories to hire new workers.
"This is exactly the kind of virtuous circle that provides the oomph in a healthy economic recovery," Williams said in a speech to the City Club of San Francisco.
He predicted the jobless rate will drop to 7.25 percent by the end of 2014, a level that he said fits the Fed's definition of a "substantially" improved job market.
"I would think that we would be stopping the asset purchases well before late 2014," Williams told reporters after the speech.
Short-term interest rates, now near zero, will likely stay until at least mid-2015, he said, echoing the Fed's own policy statement.
But the Fed would need to start raising interest rates "well before" unemployment reaches a level that the economy can sustain without generating inflationary pressure. That level is currently probably around 6 percent and over the long run is around 5.5 percent, he said.
Williams' view contrasts with that of fellow policymaker Narayana Kocherlakota, the head of the Minneapolis Fed, who last week called for the central bank to keep rates low until unemployment falls to 5.5 percent, as long as inflation does not threaten to breach 2.25 percent.
"It would be prudent," Williams said, to start stop buying assets and start raising rates well before then because it takes a while for monetary policy to work its way through the economy.
Williams, who voted for the stimulus at the mid-September Fed's policy-setting meeting, acknowledged recent improvements in the economy, marked by a rise in auto sales and "signs of life" in the housing sector. Housing construction, in particular, will be a key source of growth for the economy over the next few years, he said.
But even though the economy is "on the mend," it would be stuck in gear without new Fed stimulus, he said. He described such an environment as one in which any improvement in the employment picture would likely be modest, and inflation, which has averaged 1.3 percent over the last year, could get stuck below the Fed's 2 percent goal.
Too-low inflation can too easily slip into deflation, or outright price declines, sapping economic growth as consumers defer spending in hopes their dollars will be worth more in the future.
The outlook is further threatened by the possibility of spillover from Europe's as yet unresolved sovereign debt crisis, the looming "fiscal cliff" of automatic tax increases and spending cuts that are to go into effect at year-end unless Congress acts. Uncertainty over regulatory and tax changes is also holding businesses back, he said. San Francisco Fed researchers recently estimated uncertainty has added at least one percentage point to unemployment since the Great Recession.
In light of the Fed's latest action, Williams said he now expects growth in gross domestic product to accelerate, from 1.75 percent this year to an above-trend 3.25 percent in 2014.
The jobless rate, he predicted, will likely fall to 7.25 percent by the end of 2014, and inflation will likely increase to a level closer to the Fed's 2 percent target.
With an open-ended bond-purchase program, he explained, the Fed can ramp up purchases and even expand into purchases of other assets if progress on jobs is too slow. It can also slow down or stop purchases if progress is faster than expected.
While the Fed tied its latest policy move specifically to the state of the labor market, Williams emphasized that the Fed was no less concerned about inflation.
Some observers, including the lone dissenter against the Fed's latest measures, Richmond Fed President Jeffrey Lacker, worry the stimulus could unmoor the country from the anchor of low inflation expectations.
"I want to stress, in no way has our commitment to price stability wavered," Williams said. "Inflation is something we watch carefully, and we remain determined to work toward our price stability objective."
Editing by Leslie Adler