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Dudley Says Fiscal Shock Could Cause Another U.S. Recession

Federal Reserve Bank of New York President William C. Dudley said a failure to avert a shock in fiscal policy next year could subtract 3 percentage points from economic growth and cause a recession.

If “no policy action” is taken by Jan. 1, the U.S. may suffer a 3 percentage point reduction in gross domestic product, Dudley said at a press conference in New York today. “That would be a huge shock” to an economy that’s recovering at a disappointing pace.

The fiscal tightening would result from the expiration of income-tax cuts first enacted under President George W. Bush, the end of payroll-tax reductions and automatic decreases in government expenditures. A prediction that a failure to avoid the so-called fiscal cliff would lead to another recession should be taken seriously, Dudley said. “I don’t think that’s an unreasonable forecast.”

Dudley, vice chairman of the policy-setting Federal Open Market Committee, reinforced the view expressed at the panel’s April meeting, when several policy makers said slowing economic growth or rising risks to their outlook could warrant additional accommodation, according to the minutes of the gathering. He said he would favor more easing if the labor market stagnates, the threat of deflation increases or risks to growth were to rise substantially, reiterating remarks made last week.

The pace of growth has been “disappointing” and “the headwinds retarding recovery are well known,” Dudley said. He reiterated that he expects growth of about 2.4 percent over the next four quarters and said that Europe’s sovereign debt crisis poses another significant downside risk to the outlook.

‘Very Modest’

Still, U.S. banks are “better placed” against any shocks from Europe’s crisis, with stronger capital and liquidity buffers, he said. Their exposure to “peripheral” Europe is also “very modest,” he said.

“That doesn’t mean the U.S. is completely insulated from what happens in Europe,” he said.

The economy in New York City is “doing quite well” and has become less dependent on Wall Street, Dudley said. Tourism to New York has helped, and has been “really quite a success story,” he said.

The FOMC said last month it planned to keep its benchmark interest rate near zero until at least late 2014, reiterating a plan announced in January. The Fed has kept the rate near zero since December 2008 and bought $2.3 trillion of bonds in two rounds of asset purchases.

‘Earlier Stage’

Dudley endorsed the 2014 interest-rate plan. He said he “would be willing to consider tightening policy at a somewhat earlier stage if growth strengthened sufficiently” or “if there was evidence of a genuine threat to medium-term inflation.” Under those circumstances, he said he would expect “the first step would be to bring in the late 2014 date of the policy guidance.”

Dudley said he anticipates inflation to “remain moderate and close to our objective” of 2 percent. The economy “continues to operate with significant slack” and inflation expectations “remain well-anchored,” he said.

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