By Howard Schneider
WASHINGTON (Reuters) -An interest rate increase will likely be warranted "shortly after" the Federal Reserve ends its bond purchases in March, and the central bank should also begin reducing its bondholdings as soon as the summer to attack "alarmingly high" inflation, Federal Reserve Governor Chris Waller said on Friday.
The Fed this week agreed to end its pandemic-era accumulation of government bonds by March, a precursor to raising interest rates, as policymakers acknowledged inflation was not easing as quickly as expected and required them to be ready to tighten monetary policy.
"The appropriate timing for the first increase in the policy rate...will depend on the evolution of economic activity," he said in prepared remarks to the Forecasters Club of New York. But with maximum employment close and inflation high, he said, "I believe an increase in the target range for the federal funds rate will be warranted" at the Fed's March meeting.
In response to a question later, he said the Fed should be tightening financial conditions as well with its second tool at hand, the balance sheet.
The Fed until November had been buying $120 billion a month of Treasury bonds and mortgage backed securities during the pandemic, with its bondholdings now in excess of $8.2 trillion. Initially approved as a way to keep financial markets functioning at the outset of the health crisis, the program of quantitative easing also served to hold down long-term interest rates.
During its last rate hiking cycle, beginning in 2015, the Fed held its balance sheet steady for two years by reinvesting the proceeds of maturing bonds, preferring to focus on raising interest rates only during what was then a sluggish recovery.
No such restraint is needed this time, Waller said.
Describing his approach to the upcoming withdrawal of monetary stimulus, Waller said the Fed should "do some hikes, see what the impact is. Does inflation back off like most of us think it will the second half?"
"If it doesn't then we have to move faster, we have to do more. Balance sheet runoff would help in that" by allowing long term rates to rise.
Waller spoke at a turning point for the Fed, and central banks globally, as they navigate away from offsetting the pandemic towards a head-on battle with inflation.
While the new Omicron coronavirus variant poses the risk of slower growth, "cutting the other way, we also do not know if Omicron will exacerbate labor and goods supply shortages and add inflation pressure," Waller said.
The Fed this week signaled it may need to raise rates in three 0.25 percentage point steps this year in response to inflation running at multi-decade highs and well above the central bank's 2% target.
Waller was among the earliest Fed officials last year to argue that the turn away from pandemic-era stimulus should happen sooner than later because of the risk inflation would prove more persistent than initially expected - a view adopted by his colleagues as the fall progressed and price continued rising.