(Reuters) - Prospects for the U.S. economy have brightened now that fiscal stimulus from Washington appears more likely, so the Federal Reserve will need to keep raising rates and eventually trim its bond portfolio to avoid an overheating, one of the most influential Fed policymakers said on Thursday.
The comments from New York Fed President William Dudley, while sounding some cautious notes, were perhaps his most optimistic in years and reinforced the notion that the core U.S. central bankers are confidently on the road to tighter monetary policy after having hiked interest rates twice in three months.
Dudley said recent inflation readings had made him more confident that prices, which have been below-target since the recession, will stabilize up around 2 percent. He also cited "significantly lower" risks to overseas economies, good U.S. jobs growth, and promises of tax cuts, spending and deregulation from the Trump administration for the improving picture.
"While there is still considerable uncertainty about fiscal policy ... it seems likely that it will shift over time to a more stimulative setting," he said at the University of South Florida Sarasota-Manatee. "Consequently it appears that the risks for both economic growth and inflation over the medium to longer term may be shifting gradually to the upside."
He added: "It seems appropriate to scale back monetary policy accommodation gradually in order to reduce the risk of the economy overheating, and to avoid a significant inflation overshoot in the medium term."
Dudley, a close ally of Fed Chair Janet Yellen and a permanent voter on policy, had a big hand in setting the stage for the mid-March hike, which brought the key policy rate to a range of 0.75 to 1 percent. Fed forecasts suggest two more hikes are expected this year.
An easing of financial conditions since the November election of President Donald Trump - rising stocks, narrowing credit spreads, and falling bond yields - helped prompt the decision, Dudley said. He also repeated an assertion from 2014 - to some surprise at the time - that financial conditions play a direct role in Fed policy decisions because they influence the economy.
Markets mostly reacted positively to the election on expectations of fiscal stimulus, though Republican plans to revamp health care legislation fell through last week, causing stocks to fall.
Turning to the central bank's record $4.5 trillion balance sheet of bonds, which it acquired in the wake of the financial crisis, Dudley said he expects longer-term market yields to rise when the Fed finally outlines a plan to reduce its holdings.
"Presumably, financial conditions would tighten by more if we were to end reinvestments earlier and more abruptly," he said. "This suggests a better course may be to taper reinvestments gradually and predictably."
He added that the Fed, though it has not officially ruled it out, is not contemplating actively selling its some $2-trillion stable of mortgage-backed assets, but would rather let them mature and run-off naturally.
Reporting by Jonathan Spicer; Additional reporting by Sam Forgione; Editing by Chizu Nomiyama and Diane Craft