A member of the Federal Reserve’s policy-setting body suggested Monday that the central bank could keep short-term interest rates low until 2012 to encourage economic growth, but that it also could use some of its newer monetary tools to check excessive inflation if it materializes in the current economic recovery.

James Bullard, the president of the Federal Reserve Bank of St. Louis, is a new member of the Federal Open Market Committee, which faces tough, unprecedented policy decisions this year as the central bank unwinds first-time programs it launched during the financial crisis to prevent a second Great Depression.

The programs include “quantitative easing” measures designed to help keep interest rates low and to pump ready cash – liquidity – into the financial system. The “QE” supplemented the FOMC’s principal policy mechanism: setting the Federal Funds rate, the short-term benchmark interest rate banks charge each other for overnight borrowing.

At the height of the crisis, the FOMC cut the Fed Funds rate to about zero, where they remain today; a reversal now could rattle fragile financial markets still on the mend.

“You could take back some of the quantitative easing, not in a really rapid way, but in a slow way as the economy improves--that might be a helpful way to proceed while you are waiting for the day to raise interest rates,” Bullard said in an interview with FOX Business.

Bullard’s comments came two days before Fed Chairman Ben Bernanke testifies to a House committee about the central bank’s plans and options in winding down its multi-trillion dollar financial stability programs.

With the economy marking two quarters of expansion, Bernanke and his fellow FOMC members enter risky, uncharted policy waters: the Fed launched many rescue programs for the first time during the crisis and now for the first time is confronted with closing them. Mistakes could plunge the economy back into recession -- or conversely trigger too much growth, overheating the economy and generating high inflation.

“It’s always a tough balancing act,” Bullard said. But it is especially tough now, he said, because of the Fed’s policy innovations: “We’ve got to be very good at what we do” to unwind them in an orderly way, he said.

“You want to…foster recovery over the next year and into 2011 and you want to make sure you’re on track…(But) the economy can be very unpredictable,” he said, “So if it goes in the wrong direction here, we have to be prepared to move.”

On any decision to raise the Fed Funds rate, he said, “If you look at…how the (FOMC) has behaved in the past, it’s been two-and-a-half to three years before we’ve raised rates after the end of a recession. So if you think the recession ended in the summer of 2009, two-and-a-half years later is a long ways—it’s all the way to 2012.”

He added that the FOMC is also sensitive now to post-crisis criticism that it helped create the financial and housing bubbles by keeping interest rates too low for too long after the 2001 recession and the attacks on 9/11.
“I think that will be a big factor in how the [FOMC] plays this going forward,” he said.

Bullard joined the FOMC in January as part of a regular annual rotation of membership among the 12 regional Federal Reserve bank presidents and is considered a policy moderate. On his current economic view, he said:

--the recovery “is on track.” After it grew at a 2.2% annual rate in the third quarter and a 5.7% annual rate in the fourth quarter, he sees “good growth” in the first half of 2010 and, even with government stimulus spending ending this year, real GDP growth at “above 3%” in 2011. But he said that pace of growth is “not strong compared to what we’ve seen…coming out of very deep recessions in the past—coming out of a very deep recession, you’d see a lot of growth and we’re really not predicting that.” He said “damaged” mortgage and financial markets remain a drag on the economy. He added he does not expect a double-dip recession, which some analysts fear, because “just statistically, it just doesn’t happen very often.”

--the drop in unemployment to 9.7% in January, from 10% in December, was “welcome news.” But he said “it will take time” for the economy to create jobs and return to full employment levels, generally regarded by many economists at about 5%.

--inflation “remains under control,” but inflation expectations “have crept up a little bit over the last year.” Bullard said, “I think the risks…are shifting now toward the upside in the medium term, where you might get more inflation in the medium term if you don’t manage your affairs properly.”

--the housing market has “stabilized,” but recent data “has been mixed, so we are watching that very carefully….I’d just expect a stable housing market, where prices are more or less steady and maybe (housing) starts are going up a little bit. But, you know, we have too many houses (available for sale), so I wouldn’t expect that to really boom on us.”

In Bernanke’s testimony Wednesday, the Fed chairman is expected to highlight one new policy tool in particular to help the Fed manage economic growth: paying interest on “excess reserves” banks keep on deposit at the Fed. Congress granted the central bank the authority to make such payments for the first time in 2008, as part of the $700 billion TARP bank bailout.

The Fed can use the payments to soak up extra cash in the financial system that might be used for higher lending and risk overheating the economy.

The interest rate the Fed pays banks can also help target the level of the Fed funds rate. The theory is that banks would prefer parking their extra cash at the Fed to earn interest risk free-- rather than lend it to each other or to consumers, businesses and other riskier borrowers—and that the rate on excess reserves creates a floor on the market rates that previously were managed largely by changes in the Fed Funds rate.

But the power to vacuum up excess cash in the economy took on critical importance during the financial crisis as the Fed’s launched its new liquidity programs: luring excess reserves by paying interest on them gave it an additional tool to help balance and fine tune titanic, unparalleled money flows.

The Fed is currently paying banks 0.25% on more than $1 trillion in excess reserves. You can read more about excess reserves at http://www.newyorkfed.org/markets/ior_faq.html.

As part of its QE effort, the Fed also began big purchases of debt securities to help keep interest rates low, including $1.25 trillion in bonds backed by mortgages. Such purchase create higher demand for securities, which raise their prices, and interest rates move inversely to bond prices—the higher the price, the lower the interest rate (return).

But the Fed will end its MBS purchases in March, which some analyst worry could send mortgage rates shooting back up. Rates could jump even higher if and when the Fed begins to sell the securities.

Bullard predicted, however, that the Fed could wind down its MBS program with minimal impact on mortgage rates.

“I think we’ll get a good transition at the end,” he said. “I think we should stay open on the asset purchase program” for possible additional securities purchases, depending on the direction of interest rates, he said.

But Bullard said he believes the next moves in the program would “more likely (involve) sales, if the economy continues to improve. I wouldn’t say anytime soon….You’d start off with very small amounts, very minor amounts and then you’d test the waters and see how that goes.”