Fed's vice chairman expects recession to quell inflation

Kohn Says Fed Weighs Need for More Rate Cuts

By Jim Brumm
Reuters
Tuesday, February 26, 2008

http://www.reuters.com/article/ousiv/idUSN2636487720080226

WILMINGTON, North Carolina -- A top Federal Reserve official said on Tuesday that a weakened U.S. economy was a bigger worry than higher inflation, suggesting a willingness to lower interest rates further as the central bank tackles "difficult times."

"I do not expect the recent elevated inflation rates to persist," Fed Vice Chairman Donald Kohn told business school students at the University of North Carolina at Wilmington.

"In my view, the adverse dynamics of the financial markets and the economy have presented the greater threat to economic welfare in the United States," he said.

Kohn painted a gloomy picture of economic prospects. Retail sales and manufacturing data have been weak, and surveys of consumers and businesses in the current quarter have been almost uniformly downbeat, he said.

The central bank has wanted to reassure "lenders and spenders" that it stands ready to prevent "an especially adverse outcome," he said.

"Whether the Federal Reserve has done enough in this regard is a question this policy-maker will be weighing carefully over coming months," Kohn said.

Kohn acknowledged that a recovery in shaky financial markets was likely to take time, and said the correction in the beleaguered housing sector has further to go. He also said policy-makers must take into account the possibility of "very unfavorable developments."

"We have the tools," Kohn said. "As Chairman Bernanke often emphasizes: We will do what is needed."

... Hawks vs. doves

The central bank has already cut base interest rates to 3 percent from 5.25 percent since mid-September, including an emergency three-quarter point rate cut announced on January 22 and a further half-point cut just eight days later.

Kohn's remarks coincided with the release of Fed documents showing that a majority of the 12 regional Fed branches had backed aggressive rate cuts last month, while directors at the Dallas and Richmond banks favored leaving rates unchanged.

Dallas Federal Reserve Bank President Richard Fisher, a noted hawk who voted against the second rate cut, said separately that inflation was a worry, highlighting a split on the Fed's policy committee.

"I'm more concerned about inflation than I have been of late. It's a growing concern. ... I do have a concern that it's beginning to feed into expectations," Fisher told the Public Broadcasting Service's "Nightly Business Report."

Investors, however, saw the Fed's No. 2 official as offering a better guide to future policy action and his remarks, on the eve of congressional testimony by Fed Chairman Ben Bernanke, lifted the Dow Jones industrial average on hopes of an additional lowering of interest rates.

The Fed's next scheduled meeting is March 18 and interest rate futures markets imply a 96 percent likelihood the central bank will reduce rates by another half point, to 2.5 percent.

Bernanke delivers the Fed's semi-annual report on the economy in two days of testimony on Wednesday and Thursday. Both hearings start at 10 a.m. ET.

In economic projections released last week, the central bank lowered its growth forecasts for 2008 and raised its projections for unemployment and inflation.

... Recession risk

"Reading between the lines here, the slowdown in the economy that we're seeing today is likely to curb inflation in the second half of the year," said Mark Vitner, an economist with Wachovia in Charlotte, North Carolina. "Trying to fight inflation today is like fighting the last war -- right now the Fed needs to focus on making certain that we avoid recession."

Recent higher readings on inflation, such as the 4.3 percent year-on-year rise in the consumer price index in January reported last week, are "disappointing," Kohn said.

He added that higher costs of energy and imports may be passing through to core consumer prices -- a point of worry to his colleague, Fisher.

A government report on Tuesday showed U.S. producer prices jumped by a surprisingly steep 1 percent last month, with core prices, which strip out food and energy costs, up a sharper-than-expected 0.4 percent.

Some financial market participants have begun to worry that rising prices may restrict the Fed's ability to ease monetary policy to spur an economic rebound.

But Kohn said inflation expectations "have appeared reasonably well anchored, giving (the Fed) room to focus on supporting economic growth." Even so, the central bank will continue to monitor the inflation situation "very carefully," he added.

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