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Closing ranks, Fed officials push back on 'out of sync' markets

William C. Dudley, president and chief executive officer of the Federal Reserve Bank of New York, answers questions during a lunch at the Co
William C. Dudley, president and chief executive officer of the Federal Reserve Bank of New York, answers questions during a lunch at the Co

By Jonathan Spicer and Alister Bull

NEW YORK/WASHINGTON (Reuters) - In remarkably similar tones, two influential Federal Reserve policymakers on Thursday sought to dissuade investors that monetary accommodation was fading any time soon, each going so far as to say markets have misinterpreted the U.S. central bank's intentions.

The separate speeches from New York Fed President William Dudley and Fed Governor Jerome Powell underscore how uneasily U.S. policymakers have been watching the sharp retrenchment in global markets since last week, when the central bank unveiled a timeline for the reduction and eventual end to asset purchases.

The concerted effort this week by not only Fed officials but also European central bankers appeared to be working. Global stock and bond markets rose on Thursday as fears eased of an imminent end to stimulus for the world's largest economy.

Financial market conditions started tightening last month but accelerated sharply last week when Fed Chairman Ben Bernanke said the central bank expected to reduce the pace of bond buying later this year, and to end the QE3 program altogether by mid-2014, if the economy improves as expected.

But Dudley said the so-called quantitative easing program, or QE3, would be more aggressive than the timeline Bernanke outlined if U.S. economic growth and the labor market turn out weaker than expected. The timeline depends not on calendar dates but on the economic outlook, he argued.

"Economic circumstances could diverge significantly from the FOMC's expectations," Dudley told reporters at a briefing at the New York Fed's headquarters, referring to the policy-setting Federal Open Market Committee.

"If labor market conditions and the economy's growth momentum were to be less favorable than in the FOMC's outlook — and this is what has happened in recent years — I would expect that the asset purchases would continue at a higher pace for longer," he said.

Financial markets have been rocked since Bernanke's comments, with yields on 10-year U.S. Treasury debt spiking to near a two-year high. The across-the-board higher cost of borrowing runs the risk of tripping up a U.S. recovery that is showing signs of resiliency but has faltered the last few years.

Powell also stressed that the reduction in QE3 could be delayed and in all likelihood "will continue for some time." The $85-billion pace could be reduced more quickly than currently planned, or even boosted if needed, he told the Bipartisan Policy Center, a Washington think-tank.

"Market adjustments since May have been larger than would be justified by any reasonable reassessment of the path of policy," Powell said.

"To the extent the market is pricing in an increase in the federal funds rate in 2014, that implies a stronger economic performance than is forecast either by most FOMC participants or by private forecasters," he added.

A third Fed policymaker, Dennis Lockhart of the Atlanta Fed, like Dudley and Powell argued on Thursday that the economy's path will determine the fate of the central bank's bond buying. But he added that it would be appropriate to pull back a bit if the economy performs as expected.

"There is no 'predetermined' pace of reductions in the asset purchases, nor is the stopping point fixed," Lockhart said in remarks prepared for delivery to the Kiwanis Club of Marietta.

INVESTORS VS POLICYMAKERS

Frustrated with fitful U.S. recovery from the Great Recession, the central bank has kept the federal funds rate near zero since late 2008 and has promised to keep it there at least until the unemployment rate falls to 6.5 percent from 7.6 percent now, as long as inflation stays below 2.5 percent.

According to futures contracts at the Chicago Board of Trade, traders had brought forward expectations for the first interest-rate hike to late 2014 despite published forecasts that show most Fed policymakers don't expect to tighten until 2015.

Dudley, a close ally of Bernanke who like Powell has a permanent vote on policy, argued recent market expectations for an earlier rate rise are "quite out of sync" with the statements and expectations of the FOMC.

Even under the timeline for reducing QE3, "a rise in short-term rates is very likely to be a long way off," Dudley said, adding that even when 6.5 percent unemployment is reached the Fed could leave rates near zero for "considerably longer."

The labor market, which the Fed is targeting with its QE3 stimulus, "still cannot be regarded as healthy," Dudley said, adding "there remains a great deal of slack in the economy."

The Fed's two main stimulus efforts - QE3 and low rates - are tied in different ways to sustainable economic growth, which for the first quarter was a below-average 1.8 percent, another worrying sign for the world's largest economy.

U.S. stocks climbed and the yields on U.S. Treasuries eased on Thursday as markets showed signs of stabilizing after the recent dramatic selloff.

Powell said that some of this disturbance was probably unavoidable, given the delicate task of communicating evolving views on the economy and Fed policy. But he also argued that real interest rates remained low by historic standards, while equity valuations looked like they were within normal ranges.

Dudley said the Fed is watching markets closely: "It's no question that tighter financial conditions will have some impact on the growth rate... But much more important than that is what this economic data actually reveals about how this tug of war between fiscal policy and improving fundamentals gets resolved."

Asked about Bernanke's attempt last week to clarify the plan for QE3, Dudley said: "Some market participants took that as a hint or a signal, and I don't think that was meant at all.

"We're trying to communicate, plain speaking, in a very transparent style," he added. "If people misinterpret that as us sending hints - I just think that's not what we're trying to do."

(Reporting by Jonathan Spicer, Alister Bull and Pedro da Costa; Editing by Chizu Nomiyama)

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