Written by Steven K. Beckner

MEMPHIS (MNI) - St. Louis Federal Reserve Bank President James Bullard said Thursday night that a Fed interest rate hike is "as far away as it ever was" in wake of the discount rate increase that the Fed announced earlier Thursday.

Bullard, a voting member of the Fed's policymaking Federal Open Market Committee said market expectations of Fed interest rate hikes later this year are "overblown."

But the market is too focused on interest rates, he told reporters following a speech to the Economic Club of Memphis. The Fed could instead tighten by reversing some of its quantitative easing.

Calling tools like reverse repurchase agreements and term deposits which would absorb reserves but not reduce the balance sheet "untested," Bullard indicated he would prefer asset sales.

But Bullard said he would expect the Fed to begin asset sales slowly and gradually.

Although his own preference is to sell assets and shrink the balance sheet prior to raising rates, Bullard said the FOMC is still debating such questions, as well as the longer run issue of what kind of monetary policy regime it wants to run.

If the Fed had to start tightening today, he suggested, the Fed would likely have to use the rate of interest paid on excess reserves (IOER), because the federal funds market has diminished in size relative to the large quantity of reserves. But he said the federal funds rate could become a more viable policy instrument by the time the Fed is ready to start raising rates if it can successfully use its various tools to drain reserves.

Late Thursday afternoon, the Fed Board of Governors announced a hike in the discount rate from 50 basis points to 75 basis points, which had the effect of widening the spread between the discount (or primary credit) rate from 25 basis points to 50 basis points. It also shortened the maturity of primary credit loans to overnight from 28 days.

Although the Fed took pains to emphasize in the discount rate announcement that it did "not signal any change in the outlook for the economy or for monetary policy...," global markets did take it that way and reacted adversely.

Asked about the discount rate hike, Bullard echoed the Fed's rate announcement in saying it does not signify or set the stage for an actual tightening of monetary policy.

"Let me be very clear: the discount rate move is part of a normalization process which is akin to our discontinuing many of our liquidity programs which we did on Feb. 1," he said, "and it does not indicate anything one way or the other about what we might eventually do with the federal funds rate...."

"That's as far away as it ever was," he said of a funds rate hike.

Bullard added that, "we haven't even moved it (the discount rate-funds rate spread) back to normal," i.e. the pre-crisis spread of 100 basis points.

Earlier, when an audience member asked Bullard about the timing of an increase in the overnight money market rate, he said it is "still off in the future..."

And he added that "the idea that's in the markets that (a rate hike later this year) is a high probability is overblown." He said rate hikes may not come until 2011.

Reprising those views in a press conference, Bullard said the market has priced in "too high a probability of tightening this year."

"Some of that probability should be moved to next year...," he said, adding that the Fed is "not going to raise rates for awhile..."

Bullard told the audience that "the markets are overly focused on interest rates." Instead, he said the Fed could choose to first tighten through quantitative channels. The Fed "could sell securities," he said. "That's one way to tighten..."

Bullard acknowledged it will be a "big challenge" for the Fed to "exit appropriately." The Fed will need to "adjust both our quantitative easing and our (target) interest rate...."

He noted the Fed has "a number of tools in place we can use" to absorb reserves, including reverse repurchase agreements and a proposed term deposits. But he warned that those tools are "untested."

"The simple way to adjust the balance sheet is through asset sales," he went on, adding that the Fed would sell assets "not in an aggressive way..." Rather, central bank sales would "start small, in a gradual way."

Bullard said the Fed might want to announce a "projected path" of asset sales so as to "help markets sort of calibrate what the Fed has in mind..." But he emphasized the Fed must "be ready to react...Everything is state (of the economy and markets) contingent and data dependent."

As the economy "improves" and "normalizes" he said it will be important for the Fed to remove monetary stimulus to avoid higher inflation, but "it is important at this juncture to have an easy monetary policy."

Bullard suggested it was premature to assume that inflation is rising on the basis of the sharper-than-expected January jump in the producer price index, saying "I wouldn't go too far with one month's numbers..."

Asked whether the Fed will need to drain reserves before it raises rates, Bullard replied that he is an advocate of using quantitative policy initially "and later on raising interest rates..."

"I don't think any decision has been made at this point" as to the timing of reserve draining operations relative to the timing of rate hikes. "If we had to raise interest rates at some point because of developments ... we would be able to use interest on reserves ... but my preferred method" is to tighten quantitatively.

He said the FOMC has yet to "coalesce on whether or how much to use asset sales or other tools like reverse repos and term deposits and how much to use interest on reserves..."

Also yet to be decided is "what is the new operating regime going to be ... a corridor system or a floor system..."

For the Fed to be able to use a federal funds rate target "we're going to have a much, much lower level of reserves...."

In the meantime, he said "interest on reserves is "probably going to be the policy tool ... We have a long ways to go before can get back to a robust funds rate market."

However, Bullard added that it is "a definite possibility" that the funds rate target could become viable by the time the Fed is ready to tighten policy "if we use some of these other tools (to drain reserves)."

In other comments, Bullard said "commercial real estate problems are very serious, and we're watching the situation very carefully." What's more, he said those problems "feed back" into the financial system. But he was hopeful that sector will improve as the recovery continues.

Asked about an International Monetary Fund proposal to adopt a higher inflation target, he said that "makes almost no sense whatsoever..."

As for why there are not more FOMC dissents, Bullard said "the consensus you think you see masks a lot of debate that goes on behind the scenes ... At the end you try to rally around the chairman."

Reiterating his concern about inflation expectations, he said "I don't think they're too dangerous at this point," but stressed the Fed will be "keeping an eye on them."

Moreover, "there is cause for nervousness" due to high budget deficits, he said.