The Federal Reserve must not forget about inflation as it battles recession, or leave interest rates too low for too long next year, policy-maker Jeffrey Lacker said on Monday.
"It is crucial that we not allow expectations of future inflation to ratchet higher during this recession," the Federal Reserve Bank of Richmond president said in a speech at the Hebrew University of Jerusalem.
"As a recovery begins, the path of least resistance is often to hold the policy rate at a low level until it is completely clear that recuperation is complete," " he said.
"The risk associated with that path is that inflation may not moderate obediently during the downturn, and may firm with the ensuing recovery."
Speaking to reporters after the speech, Lacker said that while the U.S. economy was definitely in a recession he believed it would be fairly moderate in size.
"We are in a contraction. Up until the summer it was a fairly mild recession," said Lacker, who will become a voting member of the Fed's interest rate-setting committee next year.
"I think it's definitely a recession at this point. How deep, how steep, and (how) long it's going to be is uncertain. We don't know if it's going to be a garden variety recession or something steeper. I think it's most likely to be of a fairly moderate size," he said.
Lacker has earned a reputation as one of the U.S. central bank's most hawkish policy-makers with a track record for warning on inflation.
Indeed, his comments differed in tone to the Fed's last policy statement on October 29 [ID:nTRS000089], when it lowered interest rates by half a percentage point to 1.00 percent.
In the statement, it stressed downside risks to growth remained and tamed its warnings on inflation.
The U.S. central bank has slashed rates by 4.25 percentage points since September 2007 to try to cushion the economy from a global credit crisis sparked by the deepest decline in the U.S. housing market since the Great Depression.
Investors bet that it will ease rates again at its next meeting on December 16.
Asked if rates could drop below 1 percent, Lacker said: "I haven't set a specific floor in my mind for how low."
Further rate cuts would depend on economic data, he added.
"I detected…a very distinct shift in the mood of the U.S. consumer and U.S. businesses in the middle of September and it's going to take a little while before we figure just what that translates into in terms of economic activity," he said.
UNEASY
But Lacker's remarks made plain that he was uneasy about another prolonged period of very low interest rates.
Some critics argue the Fed's policy of keeping rates at 1 percent between mid-2003 and mid-2004 was partly responsible for fueling the housing boom and subsequent bust.
Lacker made a specific reference to this view in his speech and said he found it plausible; a clear hint that he may use his vote to push for rate hikes as growth picks back up.
Lacker also spelled out two factors favoring an economic rebound sometime next year, and said this was a "reasonable expectation."
"First, monetary policy is now quite stimulative. The federal funds target rate is 1 percent, below the expected rate of inflation.
"Second, the major shocks that dampened economic activity this past year have already subsided or are in the process of doing so," he said.
He acknowledged that lower oil prices would help to bring down headline U.S. inflation in the coming months. The overall consumer price index has already moderated to a year-on-year change in September of 4.9 percent from a peak of 5.6 percent in July, as the cost of oil halved to less than $70 a barrel.
But Lacker warned this would not automatically translate into a lower core rate of inflation, referring to the inflation measure watched most closely by policy-makers that strips out volatile food and energy prices.
"While the downturn in real economic activity is going to pose challenges for monetary policy in the period ahead, it's essential that we not let inflation drift from view," he said.
