WASHINGTON — Federal Reserve Bank of New York President William Dudley Tuesday said the Fed's large, and growing, balance sheet doesn't constrain the central bank's independence, but rather reinforces its commitment to stable prices, while discouraging a premature interest rate hike.

"I think that the size and composition of the Federal Reserve's balance sheet actually creates incentives that reinforce the pursuit of the Federal Reserve's objective with respect to inflation," Dudley said in remarks prepared for a Mexico City panel discussion at the Central Bank Independence Conference, titled "Progress and Challenges in Mexico."

"Consider what would happen if the Federal Reserve failed to tighten in a timely way," he said. "Inflation and long-term interest rates would rise, and this would necessitate a larger rise in short-term interest rates and even greater pressure on the Federal Reserve's net interest margin and earnings in the future."

He continued: "In contrast, by tightening in a timely way, the Fed would prevent inflation pressures from emerging and this would limit the need for a larger rise in short-term rates in the future."

Addressing critics that worry the large balance sheet might cause the Fed to deviate from policy moves that are consistent with its dual mandate of stable prices and maximum employment, Dudley countered: "The current size of the balance sheet would also discourage a premature interest rate hike."

"In the absence of solid improvements in labor market activity, a sharp increase in short-term rates would unnecessarily reduce the Federal Reserve net interest income without any benefits in terms of achieving its dual mandate goals," he said. "Thus, the current size and composition of the Federal Reserve's balance sheet actually create strong incentives to adjust policy in a timely way."

Dudley, who votes on the Fed's policymaking Federal Open Market Committee, also said the large scale asset programs — the buying of $85 billion in Treasuries and agency mortgage backed securities each month — does expose the Fed to interest rate risks that could affect its net interest earnings, but it had didn't pose a significant risk to the bank's independence.

While the risk is real, Dudley said, "I believe it is not a big threat to the Federal Reserve's independence," because the Fed has considerable non-interest bearing liabilities on its balance sheet — particularly cash — and even if the Fed were to incur an operating loss, it can create a deferred asset on its balance sheet, eliminating the need for funding from the Treasury to the Federal Reserve. "In this sense, the Federal Reserve would retain its budgetary independence," he said.

He said a far more important threat to central bank independence "is whether the fiscal authorities act in a manner consistent with the central bank's objectives."

Central banks "may not be able to achieve their objectives when an inconsistent fiscal regime is in place," Dudley said. "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."

Dudley summed up his remarks saying, "At the end of the day, I think that the best way to maintain independence is for central bankers to use all their available monetary policy tools, including unconventional monetary policy tools when needed, to best achieve their objectives."

He added: "The historical record is clear: Central bank independence tends to lead to better monetary policy outcomes. But, the causality also runs in reverse: Good monetary policy outcomes help ensure monetary policy independence."

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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