Fed must heed markets on inflation, Hoenig says

SHERIDAN, Wyoming (Reuters) - A sell-off in U.S. government bond markets last week may reflect worry over inflation and was a warning to the Federal Reserve to begin tightening policy, a top policy-maker said on Wednesday.

"I suspect we are experiencing the first signs of the markets' concerns in the rising rates and increased volatility in longer-term Treasury markets," Federal Reserve Bank of Kansas City President Thomas Hoenig told a local business audience in prepared remarks.

U.S. government bond yields spiked sharply higher last week and the gap between 2- and 10-year bonds widened to a record 2.75 percentage points, prompting speculation that the Fed may ramp up a multibillion-dollar asset purchase program.

But Fed officials have said they are still figuring out what is driving this steepening in the yield curve -- concerns over the U.S. fiscal deficit or more optimism about a U.S. economic recovery -- hinting they won't decide before their next scheduled policy meeting on June 23-24.

Hoenig implied that he did not favor an increase in the purchase program, which would bloat an already-swollen Fed balance sheet and potentially stoke inflation, saying:

"I suggest strongly that we need to be alert to the markets' message and begin in earnest to bring monetary policy into better balance before inflation forces our hand."

Hoenig said the Fed must start tightening policy to keep inflation low.

"Starting from where we are today, it is clear that interest rates must rise. As the economy recovers, even at a modest pace, resource demands will begin to increase.

"At this point, the current level of monetary accommodation will need to be withdrawn to avoid introducing inflationary impulses," he said.

The Fed -- the U.S. central bank -- has cut benchmark interest rates almost to zero and plans to pump around $2 trillion into financial markets to prevent a severe recession from getting much worse, including the purchase of $300 billion of longer-term U.S. Treasury securities by the autumn.

Hoenig warned the central bank would face pressure to keep rates low to safeguard a recovery that is likely to be very gradual with unemployment still high.

"I hope the U.S. can avoid the temptation to take policy short-cuts as we emerge from this recession. We face difficult adjustments that must yet be made. The process will not be free of pain," he said.

Hoenig, who will be a voting member of the central bank's policy-setting committee next year, has been an outspoken critic of its approach to the financial crisis and for bailing out some companies while letting others fail.

The Fed rescued investment bank Bear Stearns in March 2008, declined to support its rival Lehman Brothers in September, but saved insurance giant American International Group in a multibillion-dollar bailout whose cost has continued to climb.

The administration of U.S. President Barack Obama has said it needs to overhaul the country's patchwork of financial regulators to prevent excessive risk-taking in the future.

But Hoenig, a former bank supervisor and one of the longest serving policy-makers at the Fed, said it would be better to implement good banking rules already in place than wasting time on a redo of the regulators.

"I suspect reestablishing and then enforcing rules that have proven effective over time will do more than the make-work exercise of regulatory restructuring," he said.

(Editing by James Dalgleish)