The Federal Reserve will not just tighten policy based on how the U.S. economy is faring, but on how well financial markets respond to the eventual interest-rate hikes, an influential Fed official said on Monday.
New York Fed President William Dudley said the U.S. central bank will unleash more aggressive rate rises if financial markets do not tighten as expected, and vice versa. He flagged short- and long-term interest rates, equities, credit spread and availability, and the dollar as areas the Fed will watch.
"How much one pushes on the short-term interest rate lever depends, in part, on how financial market conditions respond to such adjustments," he said in a speech at Baruch College.
Dudley, who repeated it seems reasonable to expect liftoff from near-zero rates around mid-2015, is a close ally of Fed Chair Janet Yellen and has a permanent vote on Fed monetary policy. His speech to students flagged the benefits of cheaper oil and also walked through the much-anticipated tightening cycle, which he said he "hopes" will begin next year.
Noting the so-called "taper tantrum" of 2013, when then Fed Chairman Ben Bernanke's mere mention of trimming the Fed's bond-buying was met with a global market sell-off, Dudley said the linkage between rate adjustments and financial markets has grown unstable.
"Imagine driving a car where the connection between the gas pedal and the engine speed was variable and uncertain. The driver would have to constantly monitor and adjust the pressure on the gas pedal to achieve the desired speed," he said.
"All else equal, less responsiveness implies larger interest rate adjustments and vice versa."
Further in the future, the Fed would stop topping up its $4.5 trillion balance sheet only after its key rate is "somewhat" higher than it is now, and in a sustainable way, Dudley said. That detail was absent in the playbook the Fed published in September.
Turning to the sharp recent drop in energy prices, Dudley said it was a "positive" for the U.S. economy because much of the extra money will be "spent, not saved" by Americans. The global price drop will also spur more monetary easing by other central banks, spurring global growth, he said.
Dudley, who often flags steps taken by the broader Fed, said he expects inflation to rise toward a 2-percent target next year despite recent softening.
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