Fed's Dudley: Rate hikes will take place gradually

The Federal Reserve will hike interest rates someday but don't expect monetary policy to tighten too quickly, William Dudley, the Fed's Bank of New York President, said on Tuesday.

Monetary authorities have said a considerable amount of time will pass after the quantitative easing program ends and rate hikes begin, though markets can expect a very gradual tightening.The Fed is currently purchasing $45 billion in Treasury and mortgage debt a month to spur recovery by suppressing long-term interest rates, a monetary policy tool known as quantitative easing.

Markets have long been concerned of the inflationary sides effects that stem from past and present quantitative easing programs and how the Fed can rein them in as the economy improves.

"My current thinking is that the pace of tightening will probably be relatively slow. This depends, however, in large part, not only on the economy’s performance, but also on how financial conditions respond to tightening," Dudley said in prepared remarks of a speech he delivered before the New York Association for Business Economics earlier.

"If the response of financial conditions to tightening is very mild—say similar to how the bond and equity markets have responded to the tapering of asset purchases since last December—this might encourage a somewhat faster pace. In contrast, if bond yields were to move sharply higher, as was the case last spring, then a more cautious approach might be warranted."

The Fed's current bond-buying program began in 2012 at $85 billion in monthly asset purchases, though a stronger economy has prompted the Fed to taper the program.

Past and present rounds of asset purchases have swelled the Fed's balance sheet to around $4 trillion today, though the Fed will shrink that figure as gently as possible.

"With an exceptionally large balance sheet there will be considerable attention on the methods that the FOMC will likely use in order to exert control over the level of short-term rates. I can’t tell you yet how we will do it, but I am fully confident that we have the necessary tools to control the level of short-term rates and the credit creation process," Dudley said, referring to the Federal Open Market Committee, the Fed's monetary policy body.

Dudley added that the Fed's 2% inflation goal is not a ceiling and added policy will remain flexible.

"My own view is that 2 percent is definitely not a ceiling. Once we reach 2 percent, I would expect that we would spend as much time slightly above 2 percent as below it, recognizing that we will hardly ever be exactly at 2 percent because of the inherent volatility in prices," Dudley said.

"If inflation were to drift above 2 percent, all else equal, then we would tend to resist such a rise. But, if inflation were slightly above 2 percent even as unemployment remained far above levels consistent with maximum employment, then the unemployment consideration would dominate because we would be further from the unemployment objective than we are from the inflation objective. This should not surprise anyone. This is what our 'balanced approach' implies."