Fed's Dudley says fiscal stimulus outlook shifts risks to upside

[NEW YORK] US government policy may further boost the economy and eventually add fuel an inflation rate that is already approaching the central bank's official target, said Federal Reserve Bank of New York President William Dudley.

"While there is still considerable uncertainty about fiscal policy and its potential contribution to economic activity, it seems likely that it will shift over time to a more stimulative setting," Mr Dudley said Thursday in remarks prepared for a speech in Sarasota, Florida.

"Consequently, it appears that the risks for both economic growth and inflation over the medium to longer term may be shifting gradually to the upside."

Mr Dudley's comments mark a shift from last year, when he and most other officials on the central bank's rate-setting Federal Open Market Committee generally agreed that risks were tilted to the downside amid tepid global growth and sliding inflation expectations. That unfavourable balance helped explain why they only raised rates once in 2016, despite projecting four at the beginning of the year.

In his prepared remarks at the University of South Florida Sarasota-Manatee, he said the US "has continued to grow modestly above its sustainable long-term pace" and "the economic outlook abroad also appears to have brightened".

2017 Hikes

Fed officials have already increased interest rates once in 2017. Projections published with the March 15 decision to tighten showed the median participant on the 17-member FOMC thought it would be appropriate to lift borrowing costs twice more this year. Investors assign better-than-even odds to such an outcome, according to the price of federal funds futures contracts.

One reason to be more confident in the outlook this year, Mr Dudley said, is inflation has risen closer to the Fed's 2 per cent target. The central bank's preferred measure, based on personal consumption expenditures excluding those on food and energy, was 1.74 per cent in January, marking the highest level of so-called core inflation since July 2014.

Investor confidence that the Fed will be able to raise rates at a faster pace this year has also brought into focus prospects for the reduction of the central bank's US$4.5 trillion balance sheet, which it amassed through three rounds of bond purchases after the last recession.

Reinvestment Strategy

Right now, the Fed is reinvesting maturing bonds to keep the size of its balance sheet constant, but has said that it will begin letting them roll off once interest-rate hikes are "well underway". Mr Dudley said he favours tapering down reinvestments "gradually and predictably" instead of stopping them all at once, to avoid an abrupt rise in long-term interest rates.

"Reducing the Federal Reserve's balance sheet and raising short-term interest rates are two different, yet related, ways of removing monetary policy accommodation," he said.

"Therefore, I would expect that, when we begin to end reinvestment, we will have to consider the implications for the appropriate short-term interest rate trajectory."

The New York Fed chief also discussed the importance of financial conditions - things like stock prices and credit spreads - in setting interest rates, and suggested they were one factor that supported the decision to raise rates this month.

"Prior to the March FOMC meeting, financial conditions were generally easing rather than becoming tighter, even as the FOMC raised its policy rate in December and market participants increasingly expected further policy tightening in the coming year," he said.

"I don't think we are removing the punch bowl, yet. We're just adding a bit more fruit juice."

BLOOMBERG