Fed's Hoenig: keeping dollar value key despite crisis

GERING, Nebraska (Reuters) - The Kansas City Federal Reserve Bank president said the Fed must stay focused longer term on holding down inflation to protect the dollar's value even though financial market turmoil is creating a sense that the "sky is falling."

"It is imperative for monetary policy to maintain the value of the dollar," Thomas Hoenig told local business leaders at an economic forum in Gering, Nebraska.

He said it was important not to overreact to financial market turmoil, which led to Monday's record points fall for the Dow Jones industrial average .DJI after a Congressional move to bail out the financial sector was voted down.

"When I read and watch the news, I get a definite sense that the sky is falling," Hoenig said. "But we need to take a deep breath and think about what is happening."

Monday's "no" vote on a bailout does not mean efforts to solve the credit crunch will be abandoned, he said, adding "we will resolve this."

The U.S. economy is "resilient" and has weathered crises in the past. It will emerge stronger from current events, especially if certain much-needed structural changes start to emerge, Hoenig said.

Hoenig is not a voting member of the Federal Open Market Committee, which sets benchmark interest rates, in 2008.

Still, economic growth will likely be sluggish into 2009 as consumer spending is blunted by high energy costs and the housing market remains dogged by high inventories.

Exports remain a significant source of strength for U.S. growth, but are likely to tail off somewhat in the face of weaker global growth, he said.

Despite risks to growth, Hoenig said the Fed cannot lose its focus on inflation, especially as recent high commodity prices work their way through to final product prices.

"Inflationary pressure is one of the concerns I have," he said. "At 5.5 percent, (headline) inflation is too high, and will have a long-term impact on the economy."

ANXIETY ATTACK

"I'll be more anxious than others to reduce excess liquidity" and start raising interest rates when that is feasible, Hoenig said.

In response to a question, Hoenig said the Fed's massive injections of liquidity into gummed-up money markets are not inflationary for now but risk an inflation bubble if not reversed in a timely fashion.

The central bank faces "a very delicate, difficult piece of surgery" to raise rates at the right time, Hoenig said. "It is a balancing act that requires great skill, great judgment."

The FOMC has set the fed funds rate at 2 percent since April, having lowered it by a total of 325 basis points from September 2007 to cushion the economy from the ravages of the financial crisis.

Financial markets are leaning toward a 50 basis point rate cut to 1.5 percent, in October.

Hoenig, long a critic of huge current account deficits run by the United States, said an era of living on borrowed money was now itself on borrowed time.

"There are long-run structural changes at work ... we now owe China coming on $2 trillion," he said.

UNSUNG HEROES

Days after the collapse of Washington Mutual, the largest U.S. savings and loan bank, Hoenig said commercial banks remain safe, especially given the safety net of the Federal Deposit Insurance Corp.

Told by a local banker that conditions are mostly "business as usual" in Nebraska, Hoenig described Main Street banks as the "unsung heroes" even as some Wall Street institutions go to the wall.

"There are regional banks, of considerable size, down to community banks, who are well capitalized, have systematic and stable sources of funds, whose capital ratios remain strong," he said. "I can't overestimate how important that is."

(Editing by Neil Fullick)