Central Banks

Thursday, November 17, 2011 - 13:45

Fed's Dudley: If QE3 Needed, It Might Make Sense to Buy MBS

(MNI) - New York Federal Reserve Bank President William Dudley said Thursday he is "very unhappy" with the economic outlook and strongly suggested he is leaning toward backing further monetary stimulus.

Dudley, the vice chairman of the Fed's policymaking Federal Open Market Committee, said the Fed "could do more" to boost the economy through communication and balance sheet expansion.

If the FOMC does decide to do more quantitative easing he made clear he would favor devoting "much" of the large-scale asset purchases to buying mortgage backed securities. He argued that would be both more helpful to the housing market and less disruptive to financial markets than Treasury purchases.

Dudley also advocated changing the FOMC's "forward guidance" about the duration of zero interest rates to let markets know under what conditions the Fed will begin raising the federal funds rate.

While monetary policy must play "an important role" in sustaining and strengthening the sluggish recovery, he said the Fed also needs help from fiscal and other policymakers in remarks prepared for delivery at the United States Military Academy at West Point.

Dudley said "the recovery has proven to be persistently weaker than expected" and "growth has been insufficient to either bring down unemployment significantly or to achieve a self-reinforcing cycle of strengthening confidence, demand, income and employment."

He said "the latest news on the U.S. economy is somewhat more encouraging," but said "we should not take much solace from that."

Dudley anticipated that fourth quarter GDP growth "could be somewhat higher" the the 2.5% estimated third quarter pace. And he forecast growth of about 2.75% next year.

But the economy continues to face "significant downside risks, mostly related to the stress in the eurozone," he said, adding, "We cannot be satisfied with the current state of the economy or the outlook for the next few years. The economy is operating far below its productive potential. ... The unemployment rate is unacceptably high at 9%."

Warning that the economy "will have trouble building momentum" if households continue to restrain spending, Dudley said "monetary policy will continue to have an important role" in "sustaining aggregate demand at a time that the deleveraging process is not yet fully complete and credit availability remains impaired."

He said "sustained low interest rates" are needed to "help support financial asset and house prices, induce households and firms that do not have high debt to save less and spend more, and enable households that do have high levels of debt to refinance them at lower rates. This reduces the amount of deleveraging that has to take place."

However, because the Fed has exhausted its ability to lower short-term interest rates, Dudley said "it becomes progressively more difficult to induce households with low-debt to bring forward consumption by buying motor vehicles or other consumer durables, and to provide further support for asset prices and household net worth."

What's more, "problems in housing mean that this sector is relatively unresponsive to the low level of interest rates," he said.

But the Fed is "not out of ammunition," he said, saying the Fed still can deploy unconventional tools of communication and balance sheet expansion to ease monetary policy.

"We could do more in both directions," he said. "For instance, we could elaborate on our forward commitment to keep short-term rates low. Indeed, I believe it would be desirable if the committee were able to provide additional guidance as to the economic conditions that the committee would expect to see before raising interest rates."

"And we could purchase more longer term financial assets," he added.

Dudley said that "if additional asset purchases were deemed appropriate, it might make sense to do much of this in the mortgage-backed securities market."

He said "this would have a greater direct impact on the housing market and would be less likely to disrupt market functioning compared with further purchases in the Treasury market."

The FOMC must "recognize the costs as well as the benefits of further action," though, Dudley said. "Forward commitment entails some risks to our credibility since it is difficult to capture all the considerations that go into policy judgments in simple and concise language."

Dudley said balance sheet expansion also has potential costs, noting that some "may view balance sheet expansion as sowing the seeds of future inflation," which he called "an incorrect view." Also "balance sheet expansion increases the amount of interest rate risk in the Federal Reserve's portfolio of assets and could, if carried to an extreme, harm private market functioning."

But after citing those potential costs, Dudley indicated he is leaning toward doing more.

"For my own part, I am deeply unhappy with the current forecast of prolonged high unemployment, and will continue to review whether there is more that we could do that would bring more benefit than cost," he said.

While "monetary policy must do its part," Dudley said "there is a strong case for complementary policy actions because such actions can help secure better outcomes than can be achieved through monetary policy alone."

"If we are to achieve the best possible recovery and build for the future, we will also need ongoing efforts across four broad fronts: financial stability, housing policy, fiscal policy and structural adjustment to foster more sustainable U.S. growth and a more balanced global economy," he said.

While budget deficit reduction is needed, Dudley stressed that it should be deferred because "ongoing support for demand from the public sector at a time when many households are deleveraging sustains jobs and incomes."

** Market News International **

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