A Federal Reserve policymaker warned that the central bank's vow to keep rates unusually low for a long time could, if misread, perpetuate the boom and bust cycle that plunged the United States and the world into recession.
Markets may confuse the policy with the 'interest rate peg' policy, in which rates do not adjust in response to shocks, St. Louis Federal Reserve Bank President James Bullard said in remarks prepared for delivery to a conference in Stockholm.
In particular, multiple equilibria or 'bubbles' are possible, he said at the event, which is sponsored by Swedish bank Swedbank.
Despite noting risks associated with the extended period promise, Bullard has backed the Fed's decision to renew that pledge at its April meeting.
On Thursday, Bullard noted the policy can be successful at providing additional stimulus to an economy when borrowing costs are near zero, as they have been in the United States.
Since the April meeting, evidence the U.S. economic recovery is accelerating has piled up, although it has been tempered by worries Europe's sovereign debt crisis could deliver a shock to financial markets.
On Wednesday, reports said new U.S. home sales reached a two-year high and durable goods orders surged in April.
Most of the financial firms that deal directly with the Fed do not expect it to begin raising rates until 2011, a Reuters poll conducted on May 10 showed.
The U.S. central bank cut rates to the bone in December 2008 and then flooded the financial system with hundreds of billions of dollars to pull the economy out of the worst crisis since the Great Depression.
Bullard, a voter on the Fed's policy setting panel, is not viewed as among the most stringent inflation hawks among policymakers.
However, he has emerged as a vocal advocate for quickly shrinking the Fed's extensive quantitative easing efforts by selling off some of the mortgage-related debt the central bank has bought.
Flooding financial markets with bank reserves to induce economic growth, as the Fed's asset purchases did, can cause inflation if markets lose faith in a central bank's commitment to drain reserves in a timely manner, he said in Stockholm.
The consensus view at the Fed, reflected in comments by Fed Chairman Ben Bernanke, is that its bloated balance sheet will shrink naturally as the assets mature or are paid off.
Bernanke has said that sales of assets are only likely after the Fed begins to raise interest rates in a clearly recovering economy and if policymakers want to speed up their withdrawal of stimulus.
However, most Fed policymakers now agree that it will be advisable to sell some off some of the approximately $1.4 trillion in mortgage-related debt the Fed bought. That is because they believe there is a risk of inflation from too big a balance sheet and because they dislike providing help for a specific sector, housing, as they do by holding so much mortgage debt.
Bullard was among three Fed officials who sought an increase in the Fed's emergency lending rate, known as the discount rate in April.
The discount rate is the rate the Fed charges for banks to borrow and is different from the interbank lending rate, or Fed funds rate, that it targets to steer the economy.
Growing sentiment in favor of raising the discount rate primarily signals comfort that the financial industry is stabilizing after the 2007-2009 financial crisis but could be an early indicator of rising support for dropping the extended period language.
(Reporting by Mark Felsenthal; Editing by Jan Dahinten)