Fed’s Plosser: take back ease once markets calm

WASHINGTON (Reuters) - U.S. financial turmoil has warranted aggressive Federal Reserve rate cuts but inflation is also a concern and the policy easing should be withdrawn as markets calm, a senior Fed policymaker said on Monday.

“The severity of events affecting the smooth functioning of financial markets suggests that rates, perhaps, should be somewhat lower than simple rules might suggest,” Plosser said in remarks to the National Association for Business Economics.

“Departures from the more systematic elements of making policy decisions must be relatively transitory and reversed in due course if we are to keep expectations of future inflation well-anchored,” said Plosser, who is a voting member of the Fed’s policy-setting committee this year.

The Fed has slashed interest rates by 2.25 percentage points since mid-September to shield the economy from a collapse in the housing market, which has chilled growth and sparked a global tightening in credit conditions.

“I’m looking for some stability in financial markets because I think that it what we are trying to insure against — some downside risks there,” Plosser told reporters after the speech. “As we get more comfortable with that…that will be a time to think about ‘OK, things are functioning like they should, it is time to take this back,” he said.

Housing’s fortunes will be critical to restoring wider market calm and Plosser said that he believed home prices would stop declining in the course of this year, helping the sector to start to turn around by mid to late 2008.

The Fed has created special Term Auction Facilities to better direct liquidity to financial institutions that need it and Fed Board Governor Randall Kroszner separately signaled that this emergency measure might be needed for a while.

“The TAF function, which I believe has had beneficial effects on financial markets to date, is expected to continue as long as necessary to address elevated pressures in short-term funding markets,” Kroszner said in remarks prepared for delivery to the Institute of International Bankers.

Kroszner did not comment on the outlook for the economy or interest rates in his prepared text.

PLOSSER: NO RECESSION

Plosser acknowledged growth was “very, very slow” at the moment, but he stressed it should pick up in the second half of the year and said that the economy ought escape a recession.

“My own forecast is that we will (skirt a recession). We will have very, very slow growth in the first half of the year…and that is uncomfortable,” Plosser said.

“But I think that there is a good chance that the economy will begin to turn around in mid-year (or) in the later half of the year, and we will see somewhat more respectable, closer to trend-like growth near the end of the year,” he said.

Doubts over the outlook for the U.S. economy as well as the muscular policy response of the Fed, have contributed to a sharp decline in the dollar, which touched a fresh low against a basket of major currencies on Monday. Lower rates potentially make dollars less attractive for foreign investors.

Plosser said it was very difficult to forecast exchange rates with any accuracy, but he acknowledged the U.S. current account deficit might be weighing on the currency.

“A lot of people have been predicting for a long time that given the size of our current account deficit, that there was going to be continued pressure on exchange rates to adjust to help eliminate that,” Plosser said.

“Indeed, that is partly what has happened. That process will no doubt continue,” he added.

Plosser said in his speech central banks are usually best served by following clear guidelines for setting interest rates in response to changes in inflation, growth and productivity.

Such rules would call for interest rates above the Fed’s current 3 percent target for the benchmark fed funds rate, Plosser said. But the unusual nature of current market turmoil justifies setting rules aside for the time being.

“We are now, perhaps, in a period of extraordinary circumstances and have deviated from the benchmarks suggested by simple rules,” he said. “But such deviations should be temporary and limited and promptly reversed when conditions return to normal.”

In particular, Plosser stressed the importance of inflation expectations and conceded these have recently grown more worrisome.

“There are some signs that they (inflation expectations) are creeping up a bit,” Plosser told reporters. “I am not panicked … but they certainly bear our monitoring.”

He also stressed that policy works with a lag and central bankers need to be forward looking in their decisions.

“No matter what monetary policy does, its primary effects on employment and output, are going to be at least nine months, 12 months, maybe even two years out. And its effects on inflation may be at least that long to,” he said.

By Alister Bull

Source: Reuters