Former Fed hawk says inflation risk "vaporized"

WASHINGTON (Reuters) - A top Federal Reserve official said on Monday that inflation risks had emphatically diminished, but another policy-maker warned the U.S. central bank must not leave interest rates too low for too long.

"I don't see any economic growth through 2009 ... Inflationary forces have just subsided. In fact, they were vaporized," Dallas Federal Reserve President Richard Fisher told Bloomberg Television in an interview.

Fisher, a voting member of the Fed's interest rate-setting committee this year, had been one of the U.S. central bank's most high-profile hawks who had dissented at every meeting against monetary policy easing until September.

In September, Fisher switched and began voting for rate cuts that have now brought the benchmark overnight funds rate to 1.0 percent from 5.25 percent in September 2007, as the Fed battles a global credit crisis sparked by bad U.S. home loans.

Fisher said his growth forecast was "on the left hand" of the range of policy-makers, hinting he may be more bearish than other colleagues on the Federal Open Market Committee.

Updated quarterly FOMC members' forecasts for growth, employment and inflation will be released on Nov 19.

Some fear that a global credit crisis will do so much harm to the U.S. economy that it will suffer the same deflationary fate as Japan, when a general and prolonged decline in prices made consumers take fright and caused bank failures soar.

Fisher acknowledged that falling energy and other commodity prices might mean that the headline U.S. consumer price index could actually fall. But he did not see that as deflation.

"I think we might see some negative numbers in terms of headline inflation for a couple of months. That does not mean we are in a sustained deflationary trend," he said.

Richmond Federal Reserve President Jeffrey Lacker said that the U.S. was already in a recession, in a rare moment of candor for a policy-maker. But he took little comfort from the ability of the resulting economic slack to keep inflation in check.

"It is crucial that we not allow expectations of future inflation to ratchet higher during this recession," Lacker told an audience at the Hebrew University of Jerusalem.

Lacker, who will be a voting member of the Fed's interest-rate setting committee next year, has been consistently hawkish on inflation.

His remarks also differed sharply in tone from the Fed statement on October 29, at which it clearly dialed-down warnings on price pressures as it cut rates to 1.0 percent.

This takes the key funds rate to its lowest level since June 2004. The Fed had held rates at 1.0 percent between mid-2003 and mid-2004 to counter a perceived danger of deflation.

Critics say this prolonged period of very cheap money was one of the factors inflating the housing market bubble, whose subsequent collapse was directly to blame for the current seizure of credit markets and chilled world growth.

Lacker made plain that it would be very tempting for the Fed to fall into a similar trap this time around, with serious potential consequences for future inflation.

"As a recovery begins, the path of least resistance is often to hold the policy rate at a low level until it is completely clear that recuperation is complete.

"The risk associated with that path is that inflation may not moderate obediently during the downturn, and may firm with the ensuing recovery," he said.

Lacker also spelled out two factors favoring an economic rebound sometime next year.

"First, monetary policy is now quite stimulative. The federal funds target rate is 1.0 percent, below the expected rate of inflation. Second, the major shocks that dampened economic activity this past year have already subsided or are in the process of doing so," he said.

(Additional reporting by Adam Entous in Jerusalem)