HONG KONG - Philadelphia Federal Reserve Bank President Charles Plosser Thursday warned that central banks globally were under pressure to solve fiscal problems, a situation which he believed must be resisted.

Plosser was responding to questions posed by participants at a seminar at the Hong Kong Bankers Club.

"Central banks around the world are under pressure to solve fiscal policy problems. In my view that is a mistake. I think we need to resist that." Plosser said, adding that historically, that has led to high inflation rates.

Elaborating on the risks of the Fed further expanding its balance sheet, Plosser said, "The balance sheet before the crisis was $800-$900 billion. Now it is $3.2 trillion. It should be about 5% higher than where they started."

"If you kept the balance sheet large all the time you are then going to come under pressure from politicians to use it for other purposes. I believe that for central banks to maintain their independence they should have a mechanism to say no... All central banks right now are in this position where they have large balance sheets."

Responding to a question on Japan, Plosser said while he believed deflation was not Japan's worst problem, policymakers there appeared to be very committed in achieving a rate of inflation of 2%, a target the Bank of Japan has explicitly set.

But Plosser said that while exchange rate mechanisms around the world are interconnected, and while countries would do what is in their best interest, he believed the consequences of such actions on the U.S. and its currency would not be too dire as long as rates remain flexible.

Plosser also raised the issue of whether the Federal Reserve itself was
causing too much risk, and driving a misallocation of resources.

"With $1.8 trillion in reserves in the banking system, the risk of inflation is not now but when banks start converting those reserves into money," Plosser said.

"Are we driving investors to take on more risk but also more duration in interest rate risk?" he added. "It is what you don't see, that is laying underneath that you have to worry about."

In his speech earlier, Plosser downplayed last week's soft March employment report, saying there have been sufficient improvements in the labor market to begin scaling back Fed bond buying straightaway and said the Fed's third round of large-scale asset purchases should be wrapped up by year's end.

As the Fed ends asset purchases and moves in the direction of eventual Fed rate hikes, Plosser also urged that the Fed widen the spread between the federal funds rate and discount rate. And he said the Fed should reinvest proceeds of maturing securities in short-term, rather than long-term assets.

But at the end of the Q&A session Plosser added, that several more months of weak job growth would "give me pause."

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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