The rule of thumb that often guides U.S. central bank interest rate policy suggests that the federal funds rate will need to remain near zero for several years, a top Federal Reserve economist said on Tuesday.
Glenn Rudebusch, senior vice president at the San Francisco Fed, said the funds rate would need to be minus 5 percent by the end of 2009 to create the level of monetary stimulus implied by the Fed's own economic forecasts.
But when the time comes to reverse unconventional policy measures enacted by the Fed to support the economy, the process should be easier than some pundits have suggested, Rudebusch said in the bank's latest economic letter.
Rudebusch analyzed the interest rate outlook in light of the latest forecasts from members of the Federal Open Market Committee, released on May 20 with minutes from the Fed's April 28-29 meeting. The FOMC sets Fed interest rate policy.
For the past few decades the Fed's target rate has tracked the level implied by the Taylor rule, which calculates the ideal interest rate for a given set of economic conditions including the unemployment rate and inflation.
That link was severed in December 2008, when the funds rate was lowered to a range of zero to 0.25 percent -- essentially reaching its zero bound -- while the economic outlook continued to weaken.
From 5.25 percent last seen in September 2007, the Fed has been able to ease the funds rate only about half as much as the policy rule recommends, he noted.
Further, the funds rate should be left near zero not just for the next six or nine months, but for several years, he said.
Interest rate futures prices currently imply that the Fed could raise its benchmark lending rate to 0.5 percent in the first quarter of 2010.
Rudebusch said the U.S. recession is so severe that the sharp increase in the Fed's balance sheet that started in late 2008 to complement the interest rate cuts will probably be reversed only slowly.
But he played down worries that more than doubling the balance sheet to more than $2 trillion would lead to much higher inflation, or that a reversal would be tricky.
The Fed's short-term loans can be unwound quickly, and its portfolio of securities can be readily sold into the open market, so there should be ample time to normalize monetary policy when needed.
(Editing by James Dalgleish)