ST. LOUIS (Reuters) - The U.S. economy is strengthening but leaders must tackle a looming "fiscal cliff," a top Federal Reserve official said on Thursday, adding that he doubted the central bank would extend a bond maturity extension program that expires at end-2012.
"It is of critical importance that the president and Congress get together and get to a solution on this," St. Louis Federal Reserve President James Bullard told reporters. "This could cause tremendous damage to the U.S. economy if it is not addressed in an appropriate way."
Bullard, who is not currently a voting member of the Fed's policy-setting committee but will be next year, stuck to a forecast for U.S. growth accelerating to 3.5 percent next year, but said this was only because he believes the cliff will be avoided.
"I don't think that the Fed can take additional action that would be powerful enough to offset the complete failure to address the fiscal cliff," he said.
President Barack Obama, re-elected to a second White House term on Tuesday and whose Democrats strengthened their hold on the U.S. Senate, must deal with a Republican-controlled House of Representatives to avoid expiring tax cuts and deep reductions in spending from potentially tipping the United States into recession.
The Fed has cut interest rates to almost zero and bought over $2.3 trillion worth of bonds to spur the recovery and bring unemployment down from 7.9 percent, its level last month.
Bullard said that improvements in the housing market and recent stability in Europe, after months of volatility caused by the region's sovereign debt crisis, were easing headwinds that had been holding back a more robust U.S. recovery. As a result, he projects unemployment will drop to 7.2 percent by end-2013.
The Fed meets again on December 11-12 and must decide what to do about a program of buying $45 billion worth of longer-dated Treasuries every month with the proceeds from the sale of shorter-dated Treasuries, dubbed Operation Twist, which expires at the end of the year.
Bullard did not think there was sufficient "space" left from the Fed's short-term holdings to extend Operation Twist.
"My sense is it is unlikely that we'd extend Operation Twist because there is only so much balance sheet that we can really use to sell short and buy long."
But he argued that policy-makers could consider replacing it with other purchases if they want to prevent policy from tightening when the program comes to an end, and indicated an openness to considering further bond purchases if needed.
"One of the advantages of the approach that we took with QE3 is that it is an adjustable amount and so we could adjust that in order to make up for any perceived tightening from the ending of the Twist program. It is definitely an option on the table."
The Fed in September announced a third round of so-called quantitative easing, dubbed QE3, saying it would buy $40 billion of mortgage-backed bonds each month until it saw a substantial improvement in the outlook for the U.S. labour market.
Bullard, viewed as an anti-inflation hawk who has previously said he would not have voted in favour of QE3, said it was still too early to gauge the impact of the program.
However, he did say that he felt that Fed policy may be much more stimulative than commonly thought, and cited research that calculated a "shadow" estimate for U.S. short-term interest rates of minus-5 percent that, in nominal terms, are currently being held near zero by the U.S. central bank.
The Fed has slashed rates to spur a faster U.S. economic recovery, and bought over $2.3 trillion of U.S. government and mortgage-backed bonds to drive down longer-term borrowing costs.
Because interest rates cannot fall below zero, the Fed has used its bond purchase program to coax more economic activity, achieving stimulus when economic models call for negative interest rates that cannot be created in the real world.
Bullard highlighted research by Leo Krippner, an economist at the Reserve Bank of New Zealand, who studied the option value of cash when interest rates are zero, to illustrate just how accommodative U.S. policy may be at the moment.
The Fed has been sharply criticized for its aggressive action to encourage economic activity and bring down the high level of U.S. unemployment by economists who fear that it is stoking up dangerous inflationary pressures in the future.
Economists already use various rules to estimate where the Fed should hold rates based on goals for inflation and output.
The best known, named after economist John Taylor, has been adapted by others, and the Fed is providing even more stimulus to the economy than recommended by this rule, Bullard said.
"According to these estimates, the shadow policy rate is currently more than 300 basis points lower than the rate recommended by the Taylor (1999) rule," Bullard told a corporate finance conference at the Olin Business School at Washington University in St. Louis in earlier remarks.
Editing by Eric Walsh