UPDATE 2-Volcker: Fed can't wait too long for policy shift

Thu Oct 15, 2009 8:21pm EDT

* No inflation threat now but if "wait, it's too late"

* China unlikely to dump U.S. assets

* Says China partly influenced by lack of alternatives (Adds foreign exchange trade reaction)

By Ros Krasny

CAMBRIDGE, Mass., Oct 15 (Reuters) - The enormous amounts of liquidity pumped into the U.S. financial system by the Federal Reserve are not inflationary "at the moment" but will become so at some point, Paul Volcker, the former Fed chairman and a White House adviser, said on Thursday.

Volcker, now an economic adviser to President Barack Obama, said it was difficult, but necessary, to start draining the billions of dollars in liquidity even while unemployment rates remained high as the U.S. battles out of recession.

"You have to act against what seems like common sense. If you wait, it's too late," Volcker said while answering questions after a speech on financial markets at Harvard University's Kennedy School of Government.

Volcker is best known for bringing down raging inflation in the United States after he was appointed Fed chairman in 1979 -- chiefly by pushing the federal funds rate, the central bank's key policy tool, to a peak of 20 percent in 1981.

Volcker's hawkish rhetoric, urging a pro-active policy shift by the Fed, helped push up the rate of the dollar against the Japanese yen to a three-week high of 90.99 yen in Asian trading, from the New York close of 90.55, according to strategists at 4CAST Ltd.

In the meantime, Volcker said the recent sharp rally in the U.S. stock market from recession lows and other signs of revival in financial markets should not lead to complacency in the push for financial reforms. Volcker chairs the Economic Recovery Advisory Board set up at the start of the Obama administration.

Financial markets have not yet fully healed, he said, and the economy remains plagued by structural imbalances that threaten to prevent a sustainable recovery taking hold from the deep recession.

"We have to regain our ability to produce goods. Moving money around does not necessarily provide dinner on the table," Volcker said. "You can't run an economy where the financial sector is making 40 percent of the profits."

Answering a question from the audience, Volcker said he doubted China would embark on a major reduction of its U.S. dollar-denominated assets, partly because the alternatives to the dollar, including the euro and the Japanese yen, do not look that great either.

China has "a great interest in the stability of the dollar," he said.

Volcker said moral hazard -- the concept that investors may take greater risks if they believe the government will protect them from suffering losses -- remained an issue in the wake of the government's bailout of several major financial institutions, by creating expectations for future bailouts.

"There is this kind of hovering concern about moral hazard that could create another crisis down the road," Volcker said.

He urged a structure in which protections were offered to commercial banks, the "backbone" of the financial system because of their key role in providing credit to the economy, but not to all classes of financial institutions. (Editing by Leslie Adler)

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