European debt woes could hurt U.S., Fed says

The Federal Reserve is closely monitoring financial turbulence in Europe as it could have repercussions for the United States and its markets, policymakers at the central bank said on Thursday.

James Bullard, president of the St. Louis Fed, argued the European crisis, which centers on worries about the high debt level of Greece and other European Union member states, poses a threat to an otherwise improving U.S. economic outlook.

"One risk to the outlook ... is the fallout from potential sovereign debt default as conditions continue to deteriorate in Greece and other countries," Bullard told an audience at Washington University's Olin Business School.

His counterpart at the Richmond Fed, President Jeffrey Lacker, said the ongoing turmoil, which has led to deadly protests in Greece, was not affecting his outlook for the U.S. economy, though the situation bears watching.

"They are something we're paying close attention to. It has the potential to develop into something that has noticeable effects. But I don't see that so far," he told reporters after a speech in Richmond.

Chicago Federal President Charles Evans also said he's monitoring the potential effects. "To the extent that it's affecting financial conditions in the United States and around the world, obviously we are concerned," he told reporters on the sidelines of a Chicago Fed banking conference.

Still, he said, he continues to expect moderate economic growth of 3.5 percent in the United States this year, with a relapse into recession "highly unlikely."

The euro and world stocks have fallen over the last three days over worries Greece's debt crisis was spreading to other weak euro zone economies. Greece is preparing harsh austerity measures as part of a European rescue package aimed at staving off a sovereign debt default.

Bullard raised the possibility of a debt restructuring, saying other countries have been through such restructurings before. "Restructuring debt, if it does come to that, you can live through it," he said.

Strains in money markets reminiscent of the early stages of the global financial crisis, in mid-2007, resurfaced this week on fears the debt crisis could choke interbank lending.

Thomas Hoenig, president of the Kansas City Fed, said the U.S. government should not neglect to address its own indebtedness, which he said could increase pressure on the central bank to keep rates low to "monetize" deficits.

Hoenig and Lacker, considered among the more hawkish members of the Fed, argued that the central bank should strive to "normalize" its balance sheet by selling some of the mortgage-backed debt acquired during the financial crisis.

In response to the most severe financial crisis since the Great Depression, the Fed not only cut interest rates close to zero but purchased more than $1.4 trillion in mortgage-backed securities.

"It makes sense ... to begin normalizing our balance sheet in advance of raising rates," Lacker said. "Normalizing our balance sheet means reducing its size (and) also returning to our traditional Treasury-only asset holdings."

Lacker said he still supports of the central bank's vow to keep rates low for an "extended period" but added he is always reassessing its usefulness.

Evans said he "totally" agrees with the Fed's "extended period" pledge, which he says equates to about three or four meetings of the policy-setting Federal Open Market Committee, or about six months.

When the time comes to tighten policy, he said, he expects the Fed to first use policy tools other than asset sales, including raising the interest rate paid on reserves and using reverse repurchase agreements and term deposit accounts to help restrict credit policy.

"After we start increasing both restrictiveness and interest on excess reserves, I would not be surprised if we then considered selling assets in order to further improve the size of our balance sheet," he said. "It's still a matter of discussion as to how we go about doing it, but that's still an order that I would see as quite reasonable."

Fed Chairman Ben Bernanke also spoke on Thursday, but did not directly address the outlook for monetary policy.

He said there were reasons for optimism on bank lending, even though credit was still tight.

[Source: By Pedro Nicolaci da Costa, Reuters, Richmond Va, 06May10]

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