Fed's Bullard says shrinking reserves key to exit

A senior Federal Reserve official said on Wednesday the U.S. central bank may start tightening financial conditions by adjusting its extensive asset purchase programs rather than raising interest rates.

The market's focus on interest rates is disappointing, given quantitative easing, St. Louis Federal Reserve Bank President James Bullard said in a presentation to a group of bankers. Markets should be focusing on quantitative monetary policy rather than interest rate policy, he said.

The main challenge for monetary policy going forward will be how to adjust the asset purchase program without generating inflation while interest rates are near zero, Bullard said.

Medium-term inflation hinges on what the Fed will do with this program, he said.

Bullard said financial market focus on interest rates may in part be misplaced because the Fed has in the past waited two and a half to three years after the end of a recession before raising rates.

Assuming that the (Fed) would behave the same way that it's behaved in the past, this could mean that the (Fed) would not start increasing rates until early 2012, he said.

However, the Fed will take into account the criticism that it fueled a housing bubble that contributed to the crisis by holding interest rates too low for too long in the early part of the decade, he said.

The Fed has committed to buy up to $1.725 trillion in longer-term mortgage-related and government securities by the end of March.

Inflation is still low, but commodity prices are volatile and uncertainty over inflation is elevated compared with the fall of 2008, Bullard said.

The expansion of the Fed's balance sheet has helped restore financial health after the financial crisis, but it creates an inflation risk, he said.

Bullard, who will vote on the Fed's policy-setting panel next year, is seen as occupying the middle of the spectrum between anti-inflation hawks and growth-promoting doves.

His concern on Wednesday about the possibility of inflation building from the Fed's bloated balance sheet was consistent with his observation recently that policymakers should be careful not to over-estimate slack in the economy.

Senior Fed officials including Chairman Ben Bernanke and Vice Chairman Donald Kohn have played down inflation risks, saying that with extensive unemployment and idle manufacturing plants, the economy has a lot of room to grow before inflation risks emerge.

Indeed, the Fed last week renewed its pledge to hold interest rates near zero for an extended period to support the fragile U.S. economic recovery, saying that policy is justified by extensive slack and low inflation.

Fed officials have voiced a range of views since their meeting on the likely pace of the upturn. Financial markets around the world are watching keenly for indications of when the Fed plans to raise rates and withdraw the billions of dollars of reserves it has provided to the financial system.

Bernanke said this week tight bank credit and the weak labor market will weigh on the recovery, while Richmond Fed President Jeffrey Lacker said he expects what he called a reasonable rate of economic growth in 2010.

(Editing by James Dalgleish)