Fed's Dudley: QE Could Increase If Labor Market Doesn't Improve

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William C. Dudley

The Federal Reserve's asset purchases would be more aggressive than the timeline Chairman Ben Bernanke outlined last week if U.S. economic growth and the labor market turn out weaker than expected, the influential head of the New York Fed said on Thursday.

Pushing back hard against market concerns over the withdrawal of quantitative easing, William Dudley stressed in a speech that the newly adopted timeline for reducing the pace of bond buying depends not on calendar dates but on the economic outlook, which remains quite unclear.

Turning to the question of when the Fed will ultimately raise interest rates, Dudley, a close ally of Bernanke, went so far as to say that recent market expectations for an earlier rate rise are "quite out of sync" with the statements and expectations of the policy-making Federal Open Market Committee.

"Economic circumstances could diverge significantly from the FOMC's expectations," Dudley told reporters at a briefing at the New York Fed's headquarters in downtown New York.

(Read More: Bernanke Bond Announcement Was Poorly Timed: Fed's Bullard)

"If labor market conditions and the economy's growth momentum were to be less favorable than in the FOMC's outlook — and this is what has happened in recent years — I would expect that the asset purchases would continue at a higher pace for longer," he said.

Speaking in Georgia, Atlanta Fed President Dennis Lockhart also emphasized that the economy's health will determine the pace of Fed bond buying. "There is no 'predetermined' pace of reductions in the asset purchases, nor is the stopping point fixed. The pace of purchases, the composition of purchases and the ultimate size of the Fed's balance sheet still depend on how economic conditions evolve."

Following a Fed policy meeting last week, Bernanke surprised markets by saying the central bank expected to reduce the $85-billion monthly pace of bond buying later this year and to end the QE3 program altogether by mid-2014, if the economy improves as expected.

Global markets have since fallen sharply, with yields on the 10-year U.S. Treasury spiking to near a two-year high.

Dudley, who has a permanent vote on monetary policy, repeated and backed the timeline Bernanke articulated last Wednesday.

But he appeared to want to bolster efforts by some of his Fed colleagues this week to calm investors' worries that less Fed accommodation will hurt the slow U.S. and global economic recovery.

The labor market, which the Fed is targeting with QE3, "still cannot be regarded as healthy," Dudley said, adding "there remains a great deal of slack in the economy."

He expects GDP growth of about 2.1 percent this year, about the same as it has been since the recession ended in 2009. But Dudley expects that to pick up next year.

Frustrated with fitful U.S. recovery from the Great Recession, the central bank has kept the federal funds rate near zero since late 2008 and has promised to keep it there at least until the unemployment rate falls to 6.5 percent from 7.6 percent now, as long as inflation stays below 2.5 percent.

Even under the timeline for reducing QE3, "a rise in short-term rates is very likely to be a long way off," Dudley said.

"Not only will it likely take considerable time to reach the FOMC's 6.5 percent unemployment rate threshold, but also the FOMC could wait considerably longer before raising short-term rates," he said.

According to futures contracts at the Chicago Board of Trade, traders had pushed forward expectations for the first interest-rate hike to late 2014 despite published forecasts that show most Fed policymakers don't expect to tighten until 2015.

The Fed's two main stimulus efforts — QE3 and low rates — are tied in different ways to sustainable economic growth.

Dudley and others at the central bank have long complained that U.S. government spending cuts and higher taxes could undercut the U.S. recovery, which has stumbled in each of the last few years.

Economic growth was revised lower on Wednesday to a below-average 1.8 percent in the first quarter, another worrying sign for the world's largest economy.

"I continue to see the economy as being in a tug-of-war between fiscal drag and underlying fundamental improvement, with a great deal of uncertainty over which force will prevail in the near-term," Dudley said.

Fed Board Governor Jerome Powell also suggested financial markets have overreacted to the prospects of Fed tightening.

"Market adjustments since May have been larger than would be justified by any reasonable reassessment of the path of policy," he said Thursday in a speech at the Bipartisan Policy Center, a Washington think-tank.

"To the extent the market is pricing in an increase in the federal funds rate in 2014, that implies a stronger economic performance than is forecast either by most FOMC participants or by private forecasters," he said in prepared remarks, referring to the policy-setting Federal Open Market Committee.

— By Reuters