The U.S. unemployment rate, rather than the inflation rate, will likely be "key" to the Federal Reserve's eventual return to normalized interest rates, but a lower top-line joblessness number will not automatically begin that tightening process, a senior Federal Reserve official said Monday.

New York Federal Reserve Bank President William Dudley, answering questions following a short speech at Queens College, said "it's very likely that a 6.5% unemployment rate is going to be key."

He was referring to the September 2012 statement by the Fed's policy-making Open Market Committee, which tagged an unemployment rate outlook of 6.5% and an inflation outlook of 2.5% as the gateway to higher official borrowing rates.

With inflation stubbornly on the low side, unemployment will probably take center stage in this decision, and so too will the question of why unemployment is falling, he said.

"So 6.5% is a threshold, not a trigger," Dudley said.

But he cautioned the central bank "could wait a considerable period of time" after reaching that unemployment level before lifting the overnight Federal Funds rate above its current zero bound. He asked, rhetorically, why unemployment is currently falling, and he pointed to the discouragingly low, and decreasing, labor participation rate as a significant contributor to the lower rate alongside job creation.

In the meanwhile, the Fed's schedule for reducing its quantitative easing effort, via $85 billion monthly bond purchases, is perhaps too much on market participants' minds, the former Wall Street banker said.

"The market's quite sensitive to this decision, to this question of tapering, and I think probably overly sensitive," Dudley said. "We've said that we want to continue till we see substantial improvement in the labor market outlook," he said.

And while there has been noticeable improvement in job creation, future momentum is not yet assured and "confidence in the outlook" remains elusive, he said.

Dudley noted that a pullback in the bond-purchase pace is "not tightening," but rather an unwinding of the Fed's unconventional easing strategy.

The New York Fed chief said he is "convinced" that the asset purchases' benefits to economic recovery outweigh its costs, adding he currently sees no potential for a "big enough or broad enough" price bubble that would threaten financial stability.

Likewise, "right now we really see nothing" that would suggest inflation is going to be a problem in the near term, particularly given only modest increases in employment compensation, he said.

Current monetary policy, which includes a close to zero-percent official short-term interest rate, the bond-buying program and expanded forward guidance to the public from the FOMC, is not operating in a vacuum. Exigent circumstances have limited the Fed's historic efforts, Dudley said.

"There's a large amount of drag from fiscal policy" that has "blunted" the impact of monetary policy, Dudley said. Those fiscal headwinds have included both lighter tax receipts and lower federal spending.

Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See www.marketnews.com.

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