May 22 (Bloomberg) -- Federal Reserve Bank of New York President William C. Dudley said policy makers will know in three to four months whether the economy is healthy enough to overcome federal budget cuts and allow the central bank to begin reducing record stimulus.
“I don’t really understand very well how the tug-of-war between the fiscal drag and the improving economy are going to sort of work their way out,” Dudley said in an interview with Michael McKee airing today on Bloomberg Television. “Three or four months from now I think you’re going to have a much better sense of, is the economy healthy enough to overcome the fiscal drag or not.”
Dudley’s remarks underscore that Fed officials have yet to reach consensus on when or how to dial back their $85 billion monthly bond-purchase program designed to spur growth and lower unemployment. Philadelphia Fed President Charles Plosser has called for reducing stimulus at the Fed’s next meeting in June, while St. Louis’s James Bullard said yesterday the purchases should continue.
“If we continue to do purchases, we’re adding stimulus,” Dudley said. “People act like if we dial the rate of purchases down, somehow we’re tightening monetary policy. What we’re actually doing is adding less stimulus.”
Asked if the Federal Open Market Committee has agreed upon a strategy to taper purchases, Dudley said, “we haven’t gotten to that point.” Dudley, 60, is vice chairman of the panel and has a permanent vote, unlike other regional Fed bank presidents, who rotate.
Federal Reserve Chairman Ben S. Bernanke told the Joint Economic Committee of Congress today that the economy remains hampered by high unemployment and government spending cuts, and raising interest rates or reducing asset purchases too soon would endanger the recovery.
“A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further,” Bernanke said. Monetary policy is providing “significant benefits,” he said.
Dudley said improvements in the economy may be obscured by a combination of tax increases and automatic federal spending cuts, known as sequestration, which are curbing growth. He estimated this “fiscal drag” at 1.75 percent of gross domestic product this year.
“The important thing to recognize about the U.S. economy is that things are actually improving underneath the surface,” Dudley said in the interview. “We don’t really see that so much in the activity data yet because of the large amount of fiscal drag.”
More Americans than projected filed first-time claims for jobless benefits in the week ended May 11, and industrial production declined in April by the most in eight months, signs that budget cuts may be rippling through the economy.
At the same time, Fed stimulus has helped propel U.S. stocks to successive records and pushed home prices higher. That has helped boost household balance sheets and consumer confidence.
“Because the outlook is uncertain, I cannot be sure which way -- up or down -- the next change will be,” Dudley said of the Fed’s bond purchases in remarks yesterday to the Japan Society in New York.
Those comments helped push the Standard & Poor’s 500 Index 0.2 percent higher yesterday. The index rose 0.6 percent today to 1,678.83 at 12:56 p.m. in New York. The yield on the 10-year Treasury note rose to 2.02 percent from 1.93 percent yesterday.
In the interview, Dudley said the goal of Fed policy is “really about achieving escape velocity. When are we going to have an economy where everything is sort of self-reinforcing, and when the jobs generate income, the income generates demand, demand generates more employment?”
“I don’t think we’re quite there yet,” he added.
Once a decision is made to begin withdrawing stimulus, “we certainly want to do it in a way that it’s not abrupt, it’s not shocking,” he said. “We want to make sure that the markets don’t overreact to our first move in terms of dialing down the rate of asset purchases, or later on actually starting to raise short-term interest rates.”
Dudley said the Fed is “revisiting” the exit strategy that it drew up in June 2011 as it sought to assure investors that it had the means to avoid igniting inflation once job growth, wages, and demand started moving up. The plan was part of Bernanke’s push for greater transparency and predictability.
He said the withdrawal principles “look a little bit out of date to us.”
That strategy calls for the Fed to allow assets to mature without being replaced. The central bank would then modify its guidance on how long it plans to keep the federal funds rate near zero and begin temporary operations to drain excess bank reserves. The Fed would next raise the federal funds rate, and finally, start selling securities.
Dudley said the Fed had the ability to “manage monetary policy effectively even with a very, very large balance sheet, a balance sheet even bigger than the balance sheet that we have today” and therefore “we don’t necessarily have to sell off assets.”
Dudley was a Goldman Sachs Group Inc. economist before joining the New York Fed in 2007. He became president of the regional bank in 2009, succeeding Timothy F. Geithner.
Asked if there was much difference between his views on monetary policy and Bernanke’s, Dudley said the two were “very much in sync.”
“We do have our debates, but at the end of the day, we usually get to the exact same place,” he said. He said he had “no idea” whether the Fed will have a new chairman when Bernanke’s second four-year term expires in January.
Dudley said he would “absolutely” support Vice Chairman Janet Yellen for the top job.
“I have tremendous respect for her ability,” he said. “She is bright. She is tough. She is determined. She’s brave. These are all the qualities that I think a Fed chairman should have.”
To contact the reporters on this story: Joshua Zumbrun in Washington at firstname.lastname@example.org
To contact the editor responsible for this story: Chris Wellisz at email@example.com