UPDATE 2-Fed's Lockhart says now is not time to raise rates

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By Pedro Nicolaci da Costa

BATON ROUGE, La., June 30 (Reuters) - The U.S. economic recovery is still too fragile to withstand tighter monetary policy, particularly with Europe's debt crisis and the BP oil spill increasing uncertainty, a top Federal Reserve official said on Wednesday.

Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, told a Rotary Club meeting that high unemployment and a tentative growth outlook mean inflation is not a concern.

"I don't see inflation as much of a current worry," Lockhart said. "If anything, there is a small risk of deflation that must be monitored."

Asked whether this would prompt the Fed to try to push borrowing costs even lower, Lockhart said: "It's appropriate to think about what we would do under a deflationary scenario. At this point, no specific planning in my view is occurring but discussion in all likelihood will be on the agenda."

At the very least, any talk of raising rates has been pushed back for the foreseeable future.

"Adjustment of monetary policy will be needed eventually, but this is not the time," he said.

Following the deepest recession in more than 70 years, the U.S. economy began to rebound last summer, and has been expanding ever since. Gross domestic product expanded at an annualized 2.7 percent in the first quarter.

Lately though, economists have begun to worry about a softening in economic activity. Many worry stubbornly high unemployment could prompt a renewed retrenchment in consumer spending, prompting the recovery to falter.

A simmering debt crisis in Europe has thrown another wrench into the outlook, making it harder for the Fed to begin pulling back from the extraordinary accommodation it has provided to grapple with the financial crisis. The central bank not only slashed rates to effectively zero, but also created an array of emergency lending programs to help ailing banks.

But while helping to restore stability, such steps had yet to completely soothe concerns about the financial sector.

"As the situation has evolved, exposure to European banks as well as foreign and local corporations in the affected countries has complicated the estimation of risk," Lockhart said.

"The concern is that continuing and possibly escalating financial market pressures will be transmitted through interconnected banking and capital markets to our economy."

These fears were already palpable in global markets, with the cost of interbank borrowing near its highest levels in a year while the U.S. stock market teeters near its 2010 lows.

OIL SPILL AND CONFIDENCE

In his speech, Lockhart also became the first Fed official to explicitly cite the ongoing oil spill in the Gulf of Mexico as a direct economic threat, perhaps not surprising considering his district is directly affected.

"I'm prepared to believe that this relentless environmental disaster is an additional factor holding back consumer and business confidence," he said. "The spill dishearten us all and, I believe, makes the public a little more reticent to assume a smooth recovery."

More broadly, Lockhart enumerated several looming threats to the recovery, including retrenchment in state and local budgets and well as a pullback from national fiscal stimulus measures.

He also reiterated long-standing concerns about commercial real estate.

"The economy has not yet arrived at a state where healthy and sustainable final demand is underpinning growth," Lockhart said. "Normalization of interest rate policy and the size and composition of the Fed's balance sheet is much desired, but I believe conditions at this moment call for patience.