FARMINGTON, Missouri (By Mark Felsenthal) - Turmoil over sovereign debt problems in Europe could weigh on the U.S. economic recovery, St. Louis Federal Reserve President James Bullard said on Monday.
"I am concerned about the situation in Europe," Bullard told reporters after a speech. "Prolonged financial market turmoil could be a negative for the U.S."
Financial markets piled pressure on heavily indebted euro zone countries on Monday and global stock markets fell as investors worried about heightened risks in Spain and Greece and ratings agencies stoked new concerns over Italy and Belgium.
Italy, which has the euro zone's biggest debt pile in absolute terms, was hit by credit ratings agency Standard & Poor's decision on Saturday to cut its outlook to "negative" from "stable".
Uncertainty in Europe is one reason why U.S. longer-term bond yields have dropped, Bullard said, as investors move into less risky assets.
Discussing monetary policy, Bullard said not to expect action for a while after the Federal Reserve ends its $600 billion bond buying program in June.
"Past behavior of the (Fed) indicates that the committee sometimes puts policy on hold," he told the Mineral Area College Foundation. "A pause allows more time to assess the strength of the economy."
While waiting to see how the economy evolves, the Fed would hold interest rates near zero, said Bullard, who is not a voter on the central bank's policy-setting panel this year.
Being on hold also signals no change to the Fed's pledge to keep rates extremely low for an extended period, he said.
In addition, it means reinvesting securities to keep the Fed's much-expanded balance sheet at whatever level it reaches after the bond-buying initiative comes to a close, likely above $2.7 trillion, he added.
He said that if the economic recovery gains pace in the second half of the year, it would be reasonable to expect the Fed's next move would be to tighten financial conditions. However, he said that U.S. growth in the first half of 2011 has been slower than anticipated.
U.S. home sales and factory activity data released last week showed the economy was stuck in low gear, although a drop in claims for jobless aid offered hope the labor market's recovery was on track.
Bullard also cautioned that stripping energy and food costs from inflation measurements may understate inflation. Fed officials have argued that despite recent jumps in the prices of commodities and food, inflation is in check because underlying measures have climbed only modestly from historic lows.
Commodity prices have logged "dramatic" increases in recent months, he said.
"Ignoring energy prices in a price index may systematically understate inflation for many years," he added.
Many Fed officials believe the best way to measure whether their efforts to keep inflation at bay are working is to look at measures of underlying inflation, because that is a better gauge of where inflation is headed.
Bullard further renewed his call for the Fed to adopt an explicit numerical inflation target.
Fed Chairman Ben Bernanke signaled after the Fed's last meeting at the end of April that the U.S. central bank is in no hurry to reverse its massive support for the modest U.S. economic recovery in which unemployment remains above what Fed officials believe is the norm. That support includes rock-bottom benchmark interest rates and will amount to $2.3 trillion in purchases of longer-term assets when the current program winds up.
Many economists and some Fed officials are concerned that inflation risks are rising. Even though oil prices have moderated recently, there is concern that the Fed is ignoring overall inflation because prices for gas and many food items are noticeably higher to many consumers.
Fed officials such as Bernanke have argued that higher energy prices reflect increased global demand from emerging markets such as China, India, and Brazil, rather than too-easy monetary policy in the United States. The chairman and others also say that there is no indication consumers or businesses expect inflation in the future.
However, Bullard said recent events show so-called core inflation that strips out volatile food and energy prices is no longer an accurate gauge of trends and raises doubts in the public's mind about the Fed's effectiveness.
Still, Bullard told reporters he believes the Fed would still be in no rush to tighten policy if it focused on overall inflation rather than underlying inflation. The main problem with an emphasis on core inflation is it makes the Fed look out of touch with the prices most consumers are encountering, he said.
"This is hurting Fed credibility to be talking about core inflation when everyone sees headline inflation," Bullard said.
(Reporting by Mark Felsenthal; Editing by Gary Hill & Kim Coghill)
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