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Its current stance raises risk of higher inflation, warns top policy maker

(DURANGO, Colorado) The US Federal Reserve must not wait too long before raising interest rates or it risks a serious problem with inflation, one of its top policy makers said on Wednesday.

‘While the current accommodative stance of monetary policy reduces the risk of recession, it almost certainly raises the risk of higher inflation,’ said Thomas Hoenig, president of the Federal Reserve Bank of Kansas City.

‘It will be important for the Federal Reserve to monitor inflation developments and inflation expectations closely, and to move to a less accommodative stance in a timely fashion,’ he said in remarks prepared for delivery to an audience of business leaders.

‘When to begin this process, and how fast to move, will be difficult decisions for the Federal Open Market Committee,’ he said, referring to the Fed’s interest-rate-setting committee. Mr Hoenig is not a voting member of the committee this year.

‘While a 2 per cent fed funds rate may be appropriate in a period of extreme economic weakness, if maintained for too long it could allow inflationary pressures to build over time,’ he said.

The Fed last month paused an aggressive rate-cut campaign begun last September and left its key overnight benchmark funds rate at 2 per cent, warning at the time that inflation risks have mounted even as risks to the economy from a housing crisis remain serious. Since then, stock markets have been battered by worries over the banking sector and the health of government-sponsored mortgage finance giants Fannie Mae and Freddie Mac on fears of home loan losses.

Mr Hoenig acknowledged that problems in the banking sector were making it harder to get credit and this was a restraint on growth, which he expected to be only subdued - but still positive - over the rest of 2008.

‘While I believe we can avoid a recession, I recognise that there are significant risks that growth could turn out weaker than I suggest here,’ he said.

This has created a ‘fine line’ for the Fed to walk between sheltering growth and keeping inflation at bay amid soaring energy and food prices.

Mr Hoenig, counted among the more hawkish Fed policy makers, made plain he erred more towards fighting inflation. ‘If an inflation psychology becomes embedded in household and business behaviour, this current rise in food and energy prices could lead to a much more persistent inflation problem.’ - Reuters

Source : Business Times - 18 Jul 2008