Fed's Kohn: Rates appropriate, but outlook cloudy

20/05/2008 - 14:52

By Kathy Finn

NEW ORLEANS (Reuters) - U.S. interest rates seem to be at the right level to help the sputtering U.S. economy without sparking inflation, but policy-makers need to be ready to adjust quickly in the face of a highly uncertain outlook, Federal Reserve Vice Chairman Donald Kohn said on Tuesday.

"With the information now in hand, it is my judgment that monetary policy appears to be appropriately calibrated for now to promote both rising employment and moderating inflation over the medium term," Kohn said to the National Conference on Public Employee Retirement Systems.

"But a large measure of uncertainty surrounds that judgment and as the economy evolves, so will the appropriate stance of policy," he added.

Kohn said the Fed will be watching inflation developments closely, and expressed concern that if longer-term inflation expectations edge higher, policy-makers will be facing "a more serious situation."

At the same time, he said officials will be carefully watching whether the U.S. economy can recover from the effects of a two-year housing slump and related credit crunch.

"We need also to carefully assess whether, after a period of near-term softness ..., the economy is likely to be on track for sustained economic expansion over time," he added.

The Fed has cut benchmark rates by 3.25 percentage points to 2 percent since September to buffer the sagging economy. It has also injected hundreds of billions of dollars of liquidity into financial markets to ease credit strains.

Kohn sounded some warning notes about the potential for inflation to gain hold and damage the economy. With persistently rising prices for energy and food, inflation has been "quite elevated," he acknowledged, and added that it appeared households were building in expectations that that would continue.

While the Fed vice chair noted a moderation in so-called core inflation -- which strips out volatile food and energy costs -- he said rising measures of inflation expectations are a concern.

"If longer-term inflation expectations were to become unmoored -- whether because of a protracted period of elevated headline inflation or because the public misinterpreted the recent substantial policy easing as suggesting that monetary policy makers had a greater tolerance for inflation than previously thought -- then I believe that we would be facing a more serious situation," he said.

(Reporting by Kathy Finn, writing by Mark Felsenthal and Glenn Somerville; Editing by Chizu Nomiyama)

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