WASHINGTON — There remains "considerable uncertainty" about the U.S. economic outlook, especially in the face of large fiscal drag, so it will be important not to declare victory prematurely, New York Federal Reserve Bank President William Dudley said Tuesday.

While the sluggish growth rate masks positive signs in the economy, those factors are being offset by significant fiscal drag, Dudley said in a speech prepared for delivery to the Staten Island Chamber of Commerce in New York.

Given the outlook, the Fed's current level of asset purchases — at $85 billion a month — is "appropriate," Dudley said, but he repeated that he would advocate increasing or decreasing the amount depending on the behavior of the economy.

"At some point, I expect that I will see sufficient evidence of improved economic momentum to lead me to favor gradually dialing back the pace of asset purchases," he said. "Of course, any subsequent bad news could lead me to favor dialing them back up again."

Echoing a recent speech, he said the benefits of the asset purchase program "exceeds the costs."

He cautioned that "In the near term, there is considerable uncertainty about the outlook, particularly because the multiplier effects from fiscal drag and sequestration are still unclear. This uncertainty should gradually decline — for better or for worse — over the coming months, as the sequester's impact takes hold and more economic data come in, giving us a clearer picture of the forward momentum of the economy."

With only moderate improvements in labor markets and "along with the large amount of fiscal restraint hitting the economy now, makes me more cautious," he said.

And while it is important not to read too much into the weak March employment data — with a disappointing 88,000 payroll jobs created — Dudley said, "this underscores the need to wait and see how the economy develops before declaring victory prematurely."

He noted that "New York Fed staff research agrees with the broad consensus that cyclical factors are the major reason for the continued weakness in labor market conditions."

Dudley said "the U.S. economy remains on the slow growth track" and while the "lackluster and disappointing performance masks the fact that the underlying conditions that support growth have been gradually improving," he cautioned that "in the near-term, this improvement in fundamentals is being offset by federal tax increases and spending cuts, which economists call 'fiscal drag.'"

He said the sequester "will result in fiscal drag of about 1-3/4 percentage points of GDP in 2013, an unusually large amount of fiscal restraint when the economy doesn't have strong forward momentum and unemployment is still elevated."

As a result, Dudley said he expects the economy to grow only 2.0% to 2.5% this year and the unemployment rate will decline "only modestly."

On the bright side, the improvements in the labor market and access to credit have fueled gains in consumer spending, while improvements in the housing market are providing a lift to the economy," he said, and "rising home prices can create positive spillovers to the rest of the economy as higher home prices lift household wealth and reduce the number of homeowners with negative equity."

Dudley said inflation remains "subdued" given the slack in the economy and labor markets, and expectations "remain well anchored at levels consistent with our 2% longer-run objective."

"Thus, I conclude that the risk that inflation could significantly exceed our 2% objective is quite low over the next few years, even if the economy were to strengthen considerably," he said.

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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