July 10, 2013 / 12:11 AM / 4 years ago

Fed Williams says moderation in unconventional tools needed

4 Min Read

SAN FRANCISCO (Reuters) - Moderation is a virtue when it comes to using unconventional policy tools to bring U.S. unemployment and inflation back to desirable levels, a top Federal Reserve official said on Tuesday.

San Francisco Fed President John Williams argued that timidity can be a virtue when it comes to using central bank tools, like bond-buying, whose effectiveness and risks are not as well known as more traditional policy levers like short-term interest rate targets.

"Uncertainty about the effects of policies is especially acute in the case of unconventional policy instruments such as using the Fed's balance sheet to influence financial and economic conditions," Williams said in a paper he is to present at a Society for Computational Economics conference in Vancouver, Canada on Friday.

The San Francisco Fed released the text of the paper on Tuesday.

Some critics, including several Fed policymakers, have warned that bond buying, also known as quantitative easing, could destabilize financial markets or unmoor inflation expectations.

The uncertainty does not mean the unconventional tools should not be used, Williams said, but only that they should be used less, and only after other methods have been exhausted, he argued.

"Indeed, once one recognizes uncertainty, some moderation in monetary policy may well be optimal," Williams said. Such an approach will bring economic output and inflation only gradually back to normal levels.

The Fed is buying $85 billion in Treasuries and housing-backed securities each month to push down long-term borrowing costs in a bid to fuel economic growth and hiring.

The bond buying is meant to add to monetary stimulus when short-term rates, which the Fed has kept near zero since December 2008, cannot be pushed any lower.

Critics, notably Nobel Prize-winning economist Paul Krugman, have accused the Fed of not acting aggressively enough to bring down unemployment, now at 7.6 percent.

Most Fed officials forecast inflation to stay at or below the central bank's 2 percent target through 2015, giving the Fed plenty of leeway to double down on stimulus and get the economy more quickly back to normal, he and others have argued.

Not so, Williams said.

"The claim that the Fed is responding insufficiently to the shocks hitting the economy rests on the assumption that policy is made with complete certainty about the effects of policy on the economy," he said. "Nothing could be further from the truth."

Williams said the sizable uncertainty around the Fed's bond-buying program means that the central bank should be about half as aggressive as suggested by some economic models.

Williams did not call for a reduction in the Fed's bond-buying program in the paper. As recently as June 28, he said the asset-purchase program was appropriate and should only be reduced once policymakers are more certain of the recovery in the job market.

Stocks dropped and Treasury yields soared after Fed Chairman Ben Bernanke in June said the Fed expected to pare back on its bond purchases later this year and to halt them altogether by mid-2014, as long as the economy progresses as expected.

Unemployment will likely have fallen to about 7 percent by then, he said.

(Corrects 14th paragraph to say half as aggressive as economic models would suggest, not half as aggressive as the Fed has been)

Reporting by Ann Saphir; Editing by Leslie Gevirtz

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