By Steven K. Beckner

(MNI) – St. Louis Federal Reserve Bank President James Bullard
expressed concern early Thursday about financial market perceptions of
the Fed’s willingness to raise interest rates and end its quantitative
easing policy in a timely way.

Bullard, a voting member of the Fed’s policymaking Federal Open
Market Committee, warned that markets could “lose faith” in the Fed’s
commitment to undo the asset purchases that swelled its balance sheet
and bank reserves. And he said markets could interpret the Fed’s stated
expectation that the federal funds rate will remain “exceptionally
low … for an extended period” as the equivalent of an inflexible
interest rate “peg.”

On his last outing Tuesday in London, Bullard said the Fed is
“really nowhere near a tightening” of monetary policy.

Bullard, in remarks prepared for the Swedbank Economic Outlook
Conference in Stockholm, said U.S. and global economic recovery remain
“on track.” He said the recovery is being buffeted by another financial
shock, but said government guarantees against failure of large
institutions should limit the financial contagion.

At the same time, though, those guarantees and other government
responses to the financial crisis have eroded the credibility of
monetary authorities, he warned.

“The policy to keep rates near zero for an extended period can
influence real activity at the zero lower bound, according to modern
monetary theories,” said Bullard, adding that “the effects depend on the
credibility of the promise.”

However, Bullard said the “extended period” policy carries the risk
that “markets may confuse the policy with the ‘interest rate peg’
policy, in which rates do not adjust in response to shocks.”

“In particular, multiple equilibria or ‘bubbles’ are possible,” he
warned.

As for the “quantitative easing” which the Fed used to supplement
its zero rate policy, Bullard said it has been effective. But he
suggested that removing this policy without creating an inflationary
impact will be tricky.

“The inflationary impact of the QE policy depends on the
perceptions of how and when the policy will be removed,” he said.

“In theory, any credible commitment to remove the policy in finite
time will work well,” he continued, but “in practice, markets may well
lose faith sooner than that.”

Bullard was cautiously upbeat about the economic outlook.

“In the U.S. and globally, the recovery remains on track,” he said,
adding that real GDP in the U.S. is expected to reach its second quarter
2008 peak before year-end. And he noted that global growth is projected
to return in 2010 and continue in 2011.

Bullard acknowledged that the sovereign debt crisis in Europe has
raised concerns of financial market contagion, but said “there are
several reasons why this new threat to global recovery will probably
fall short of becoming a worldwide recessionary shock.”

Most important, he suggested, is that “governments have made it
very clear over the course of the last two years that they will not
allow major financial institutions to fail outright at this juncture,”
he said. “Because these too-big-to-fail guarantees are in place, the
contagion effects are much less likely to occur.”

Though necessary, official responses to the crisis are “harming the
credibility earned through stable, rules-based policy,” Bullard said,
and “credibility can take a long time to rebuild.”

For this and other reasons, Bullard said “a new, more volatile era
seems to be at hand.”

** Market News International **

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