Philadelphia Federal Reserve Bank President Charles Plosser warned Tuesday that if the Fed's policymaking Federal Open Market Committee does not scale back its asset purchases in response to labor market improvements, it will lose credibility.

Plosser, not a voting member of the FOMC this year, argued there has already been enough improvement in the labor market for to reduce asset purchases at its next meeting and to end them by the close of 2013.

Plosser allowed for the possibility of increasing bond buying from the current $85 billion per month if labor market conditions were to deteriorate or if inflation expectations were to fall, but he made clear he does not expect either to happen.

He said the economy is already growing near "trend" and should accelerate to around 3%. He predicted inflation, though now running below the FOMC's 2%, should return to that target. He predicted the unemployment rate will fall to 7% by the end of 2013 and to 6.5% by the end of 2014.

Plosser contended that the "exit strategy" which the FOMC announced in June 2011 should not be greatly unchanged, although others are known to think differently.

If anything, because of the rapid growth of the Fed's balance sheet in recent months, the Fed will need to sell assets more aggressively than once thought, he said in remarks prepared for delivery in Stockholm, Sweden.

Contrary to what some of his colleagues favor, Plosser suggested the Fed get rid of its large and growing holding of agency mortgage backed securities and return to an all-Treasury portfolio as soon as possible.

At its May 1 meeting, the FOMC said it was prepared to "increase or reduce" asset purchases. And some Fed officials have raised concern that inflation is falling too far below the Fed's target, suggesting this could become a reason to increase the size of "quantitative easing."

Plosser disputed this.

"Over the past three years, average PCE inflation in the U.S. has been running about 1.8%, a bit below our 2% target," he noted. "Although inflation has been running somewhat lower than this over the past four quarters, I expect it to return to our goal over the next year or two, as inflation expectations remain fairly well anchored near our goal ... . I do not see inflation or deflation as a serious threat in the near term."

On the contrary, Plosser said he believes "our extraordinary level of monetary accommodation will have to be scaled back, perhaps more aggressively than some think, to ensure that inflation over the medium term remains consistent with our target."

Even though fiscal and other uncertainties have dampened business spending, consumer spending has lately made "a solid contribution to growth," and housing is in "a sustainable recovery," he said, and there have been "significant" improvements in labor market conditions.

The FOMC has said it wants to see "substantial" improvement in the labor market outlook, and Plosser said he believes "labor market conditions warrant scaling back the pace of purchases as soon as our next meeting."

"Moreover, unless we see a significant reversal in current trends that jeopardizes my forecast of near 7% unemployment rate by the end of this year, then I anticipate that we could end the program before year-end," he added.

Plosser warned that if the FOMC does not soon scale back its asset purchases "it would undermine the credibility of the Committee's statement that the pace of purchases will respond to economic conditions."

"Similarly, if there were sufficient evidence that conditions in labor markets had deteriorated, I would expect the FOMC to consider increasing the pace of purchases," he continued. "After all, this is the meaning of state-contingent monetary policymaking."

"But if we reach the point that markets only expect us to move in one direction - that is, toward more easing - and we become reluctant to dial back on purchases over concerns of disappointing or surprising markets, then we will find ourselves in a very difficult position going forward," he added.

Plosser repeated a call for changing the Fed's reinvestment policy that he made last month at an MNI event in Hong Kong. Since the Fed no longer has any short-term Treasury securities in its portfolio, he recommended, "Rather than reinvesting maturing and prepaid assets into longer-term assets, it might be prudent to reinvest into shorter-term assets."

He said that would give the Fed "more flexibility in managing our balance sheet as we move forward."

Plosser also repeated his call for a "corridor system" of interest rates, in which the federal funds rate would trade between a lower interest rate on excess reserves and a higher discount rate. Solely using the IOER as a rate floor would mean "monetary policy could be implemented with no limit on the size of the Fed's balance sheet."

Currently the effective funds rate lies below the 25 basis point IOER. "To make sure the fed funds rate trades above the interest rate on excess reserves, normalization will require a significant reduction in the volume of reserves in the banking system, which will result in a much smaller balance sheet for the Fed," he said.

When the FOMC revisits its exit strategy in coming weeks or months, it is likely to consider altering one key principle - that of selling agency mortgage backed securities. According to minutes of its June 2011 meeting, the FOMC agreed that "sales of agency securities from the SOMA (system open market account) will likely commence sometime after the first increase in the target for the federal funds rate."

Many Fed officials now favor holding on to MBS longer and delaying a return to an all-Treasuries portfolio than previously planned. But Plosser said the June 2011 principles "still apply" as a preferred way to go.

"Normalization should include returning the composition of the Fed's portfolio to mostly short-term U.S. Treasury securities, as it was prior to the crisis," he said. "This means that mortgage-backed securities on the Fed's balance sheet would have to be eliminated. They could be allowed to run off via maturity or prepayment, or the Fed could sell these assets."

Indeed, the current pace of balance sheet expansion "may require the Fed to sell assets at a somewhat faster pace than contemplated in 2011," Plosser 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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