Plosser says Fed may need to tighten this year

PHILADELPHIA Wed Jul 20, 2011 3:53pm EDT

PHILADELPHIA (Reuters) - The Federal Reserve may need to tighten monetary policy later this year if temporary factors holding back economic growth abate as expected, a top Fed official said on Wednesday.

Philadelphia Federal Reserve Bank President Charles Plosser told Reuters he expects the economy to grow at a 3-3.5 percent annual rate over the second half of 2011 with the jobless rate declining to around 8.5 percent by year's end.

"The more my forecast comes to fruition the more I'm going to feel like we may have to act," the noted policy hawk said in an interview at his downtown Philadelphia office. "I'd like to have a little more confidence in that forecast."

Plosser pinned the slowdown in economic growth over the first half of the year to "easily identifiable" factors, such as weather, a spike in oil prices and supply disruptions from Japan's earthquake. He also cited uncertainty stemming from Europe's fiscal morass and the wrangling over U.S. debt in Washington.

"I don't see the fundamentals of the economy as changed that much," he said. "Yeah, there's been some shocks and disruptions but the underlying forces that are going to cause us to continue a slow, moderate recovery are still in place."

The Fed cut overnight interest rates to near-zero in December 2008 and has bought $2.3 trillion in government and mortgage-related bonds to help the economy.

A sharp slowdown in economic growth early this year has led to speculation the central bank could launch a fresh round of bond purchases. The economy grew at a 1.9 percent pace in the first quarter and growth in the second-quarter does not appear to have been much stronger.

Fed Chairman Ben Bernanke told Congress last week the central bank would act if the recovery faltered but made clear that no action was imminent. Like Plosser, he said the slowdown should prove transitory.

The Philadelphia Fed chief repeated his view that inflation risks over the next year or so were to the upside and said it would take a big economic shock to convince him a further easing of monetary policy was warranted.

"If we had another financial meltdown because of something happening in Europe and markets just sort of fell apart, well, yeah, the Fed would obviously try to step in and do what it can to address that sort of massive shock," Plosser said. "But I think that the ability of monetary policy now to do much about the pace of the recovery is pretty minimal."

He said the U.S. central bank was engaged with the Treasury in laying contingency plans for the possibility of a government default if Congress does not raise the nation's $14.3 trillion debt limit in time. The Treasury has said the debt limit needs to be raised by August 2 to avoid a default.

Plosser, who rotated into a voting spot on the Fed's policy panel in January, last year opposed the central bank's most recent bond-buying program -- a $600 billion program that ended last month.

Still, he voted with the majority in supporting the program's continuation this year, saying it was important for a central bank's credibility to follow through on announced plans.

He suggested, however, he could become more vocal in opposing the Fed's easy money policies and said the argument that had underpinned the Fed's latest bond purchases, launched when deflation was seen as a risk, is difficult to make now.

The Fed launched the program last November, shortly after core inflation had touched a low of 0.6 percent. It has moved up sharply since then and registered 1.6 percent in the 12 months through June.

"If you thought policy was correct last fall ... because you were worried about deflation, now inflation is 3/4s of a percentage point higher than it was in December. What does that suggest?" Plosser asked.

"You could argue, perhaps, that if policy was right in December and now inflation is another 3/4s of a percentage point higher, now policy is too loose."

(Editing by Chizu Nomiyama)

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