* US economy continues to improve, “fiscal cliff” needs
tackling
* Fed unlikely to extend Operation Twist, could take other
action
* Research signals Fed policy may be much easier than
commonly thought
(Adds more Bullard comment on fiscal cliff, outlook)
By Alister Bull
ST. LOUIS, Nov 8 (Reuters) – The U.S. economy is
strengthening but leaders must tackle a looming “fiscal cliff,”
a top Federal Reserve official said on Thursday, adding that he
doubted the central bank would extend a bond maturity extension
program that expires at end-2012.
“It is of critical importance that the president and
Congress get together and get to a solution on this,” St. Louis
Federal Reserve President James Bullard told reporters. “This
could cause tremendous damage to the U.S. economy if it is not
addressed in an appropriate way.”
Bullard, who is not currently a voting member of the Fed’s
policy-setting committee but will be next year, stuck to a
forecast for U.S. growth accelerating to 3.5 percent next year,
but said this was only because he believes the cliff will be
avoided.
” I don’t think that the Fed can take additional action that
would be powerful enough to offset the complete failure to
address the fiscal cliff,” he said.
President Barack Obama, re-elected to a second White House
term on Tuesday and whose Democrats strengthened their hold on
the U.S. Senate, must deal with a Republican-controlled House of
Representatives to avoid expiring tax cuts and deep reductions
in spending from potentially tipping the United States into
recession.
The Fed has cut interest rates to almost zero and bought
over $2.3 trillion worth of bonds to spur the recovery and bring
unemployment down from 7.9 percent, its level last month.
Bullard said that improvements in the housing market and
recent stability in Europe, after months of volatility caused by
the region’s sovereign debt crisis, were easing headwinds that
had been holding back a more robust U.S. recovery. As a result,
he projects unemployment will drop to 7.2 percent by end-2013.
OPERATION TWIST
The Fed meets again on Dec. 11-12 and must decide what to do
about a program of buying $45 billion worth of longer-dated
Treasuries every month with the proceeds from the sale of
shorter-dated Treasuries, dubbed Operation Twist, which expires
at the end of the year.
Bullard did not think there was sufficient “space” left from
the Fed’s short-term holdings to extend Operation Twist.
“My sense is it is unlikely that we’d extend Operation Twist
because there is only so much balance sheet that we can really
use to sell short and buy long.”
But he argued that policy-makers could consider replacing it
with other purchases if they want to prevent policy from
tightening when the program comes to an end, and indicated an
openness to considering further bond purchases if needed.
“One of the advantages of the approach that we took with QE3
is that it is an adjustable amount and so we could adjust that
in order to make up for any perceived tightening from the ending
of the Twist program. It is definitely an option on the table.”
The Fed in September announced a third round of so-called
quantitative easing, dubbed QE3, saying it would buy $40 billion
of mortgage-backed bonds each month until it saw a substantial
improvement in the outlook for the U.S. labor market.
Bullard, viewed as an anti-inflation hawk who has previously
said he would not have voted in favor of QE3, said it was still
too early to gauge the impact of the program.
MORE EASY
However, he did say that he felt that Fed policy may be much
more stimulative than commonly thought, and cited research that
calculated a “shadow” estimate for U.S. short-term interest
rates of minus-5 percent that, in nominal terms, are currently
being held near zero by the U.S. central bank.
The Fed has slashed rates to spur a faster U.S. economic
recovery, and bought over $2.3 trillion of U.S. government and
mortgage-backed bonds to drive down longer-term borrowing costs.
Because interest rates cannot fall below zero, the Fed has
used its bond purchase program to coax more economic activity,
achieving stimulus when economic models call for negative
interest rates that cannot be created in the real world.
Bullard highlighted research by Leo Krippner, an economist
at the Reserve Bank of New Zealand, who studied the option value
of cash when interest rates are zero, to illustrate just how
accommodative U.S. policy may be at the moment.
The Fed has been sharply criticized for its aggressive
action to encourage economic activity and bring down the high
level of U.S. unemployment by economists who fear that it is
stoking up dangerous inflationary pressures in the future.
Economists already use various rules to estimate where the
Fed should hold rates based on goals for inflation and output.
The best known, named after economist John Taylor, has been
adapted by others, and the Fed is providing even more stimulus
to the economy than recommended by this rule, Bullard said.
” According to these estimates, the shadow policy rate is
currently more than 300 basis points lower than the rate
recommended by the Taylor (1999) rule,” Bullard told a corporate
finance conference at the Olin Business School at Washington
University in St. Louis in earlier remarks.
(Editing by Eric Walsh)
