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Fed's Dudley: Bad fiscal policy threat to central bank independence

William Dudley, President and CEO of the Federal Reserve Bank of New York, speaks during the Asia Society and Economic Club of New York lunc
William Dudley, President and CEO of the Federal Reserve Bank of New York, speaks during the Asia Society and Economic Club of New York lunc

By Dave Graham and Michael O'Boyle

MEXICO CITY (Reuters) - Unconventional monetary policy poses a small risk to central bank independence but a far larger threat comes from fiscal authorities if they insist on policies that harm the economy, a senior U.S. Federal Reserve official said on Tuesday.

Washington is locked in a bitter budget battle that the Fed has repeatedly warned creates serious headwinds for growth and hiring and could inflict another recession if it triggers a U.S. debt default.

New York Fed President William Dudley told a panel in Mexico City that massive bond buying by the U.S. central bank might potentially undermine its independence if this led to losses on its balance sheet when interest rates rise.

"While the threat is low, central bankers need to be cognizant of such risks, and clearly explain the motivations for their actions in order to mitigate such risks," he said in remarks prepared for a conference hosted by the Bank of Mexico.

"A far more important threat to central bank independence than the use of unconventional monetary policy is whether the fiscal authorities act in a manner consistent with the central bank's objectives," he told participants at the event, on unconventional monetary policy and central bank independence.

The Fed has been harshly criticized by some Republican lawmakers for an unprecedented 5 years of ultra-easy monetary policy, after it slashed interest rates near to zero in late 2008 and quadrupled its balance sheet to around $3.7 trillion via bond purchases aimed at holding down borrowing costs.

Dudley said the Fed might suffer losses on these holdings due to a rise in interest rates, which could reduce, or even wipe out, the amount it pays back to U.S. taxpayers every year.

This might expose it to political pressure if the loss forced it to ask Congress for more money. But Dudley said that problem could be avoided by an accounting technique - creating a "deferred asset" on its balance sheet - which would preserve its budgetary independence.

On the other hand, lawmakers could do much more damage to the central bank by imposing fiscal policies that drive up inflation, which monetary policy could not offset.

"Central banks may not be able to achieve their objectives when an inconsistent fiscal regime is in place. That is, monetary and fiscal authorities need to share the same objectives. When the objectives differ, fiscal dominance can become a major problem for the central bank," he said.

(Writing by Alister Bull in Washington; Editing by Dan Grebler)

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