Fed officials see soft economy; point to rate hold

SALT LAKE CITY, Utah Thu Sep 4, 2008 6:48pm EDT

SALT LAKE CITY, Utah (Reuters) - Senior Federal Reserve officials on Thursday said the U.S. economy seems on the verge of another slowdown while the most severe inflation threats may have passed, hinting that the central bank could keep interest rates at current levels for some time.

The president of the San Francisco Fed, Janet Yellen, said the economy faces "substantial headwinds" over the next few months after an "ephemeral" pick-up in the second quarter.

"My forecast is for sluggish growth in the second half of this year, with substantial downside risks," she said in a speech in Salt Lake City.

Yellen said the jobless rate could rise above 6.0 percent late this year, compared with a rate of 5.7 percent in July.

Yellen said another interest rate cut, while unlikely, could not be ruled out. The Fed, at the very least, can afford to be "patient" in any policy response.

"I am reasonably comfortable" with policy as it stands, Yellen added.

Dallas Fed President Richard Fisher, meanwhile, tempered some of his recent, more strident anti-inflation rhetoric, but still said that there was no guarantee that price pressures would ebb in sync with slower economic growth.

"While it seems pretty clear that economic momentum is slowing, the jury is out on whether lesser momentum will be sufficient to translate into relief on the price front over the intermediate to longer term," Fisher said, speaking in Houston.

There has been some belief within the Fed in recent months that the slowing U.S. economy would ultimately curb inflation, although policy-makers are divided on their confidence in that assessment.

Yellen told reporters that the tipping point for a further cut in benchmark interest rates could come if the "adverse feedback loop" -- a vicious cycle of rising unemployment, weak consumer spending, falling home prices and tight credit conditions -- were to worsen substantially.

At its current level of 2 percent, the federal funds rate is not "highly accommodative" because lending conditions in financial markets remain so tight, Yellen said.

Compared with cautious remarks in early July, Yellen saw a "favorable" outlook for inflation that "has improved the policy choice" facing the policy-setting Federal Open Market Committee.

"It seems clear that inflation risks have diminished somewhat in recent months as commodity prices have come down from their highs," Yellen said.

Fisher, however, was more cautious. "Trend consumer price inflation has accelerated over the past few months. Less clear, however, is the duration of this acceleration," he said.

Fisher has voted against the five most recent FOMC decisions on interest rates, pushing for tighter monetary policy. Yellen is not a voter in 2008 on the FOMC.

Yellen said that core and headline inflation should be "a bit over 2 percent" in 2009, adding that her outlook for lower inflation was not dependent solely on a further decline in commodity prices.

The Fed halted an aggressive interest rate-cutting campaign this year after slashing borrowing costs by a total of 3.25 percentage points, to the current 2 percent rate, to shield the economy from a collapsing housing market.

After dovish comments from Yellen and from Boston Fed President Eric Rosengren on Wednesday, as well as a string of tepid economic reports, financial markets now assume almost no chance for a Fed interest rate hike this year.

Interest-rate futures that handicap prospects for Fed policy slashed the prospects for even a one-quarter percentage point rate increase by year-end to just 4 percent from 16 percent on Wednesday.

As recently as mid-July, dealers guessed that the fed funds rate would be near 2.5 percent by year end.

Fisher and Yellen differed in their assessments of how problems in global credit markets would play out.

"I think substantial progress has been made" in healing credit markets, Fisher said, adding that "we have a way to go."

Yellen said the problems in financial markets and the credit crunch that is making it hard for consumers and some firms to borrow, "are ongoing and perhaps deepening."

(Additional reporting by Alister Bull in Houston; Editing by Leslie Adler)

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