UPDATE 2-Fed's Fisher-market dysfunction may trump inflation

(Adds comments on markets)

By David Lawder

WICHITA FALLS, Texas, Oct 6 (Reuters) - Federal Reserve Bank of Dallas President Richard Fisher said on Monday capital markets were in "semi-panic" mode and he was more worried about market dysfunction than inflation.

"I'm not as worried as I was before that we might, when the financial system was repaired, have ... inflationary pressure," Fisher, who is well-known for his hawkish views on inflation, told community bankers.

"What I'm more worried about is how dysfunctional the system has become and what we, as the lender of last resort, need to do to encourage the liquidity to flow."

Fisher has been the Federal Reserve's most vocal inflation hawk in recent months, voicing concern about businesses passing on higher costs for energy and other inputs and the threat of rising inflationary expectations among consumers. He has dissented at several recent Fed policy meetings, arguing in August for a hike in rates when the held them steady.

Fisher, however, voted in a unanimous decision of the Fed's policy-setting committee for no change in rates at the latest meeting on Sept. 16 after the government hastily arranged several major bailouts of financial companies.

The next Federal Open Market Committee monetary policy meeting is Oct. 29-30.

Comparing credit markets to a clogged sprinkler system in need of repair, he said this was having a detrimental effect on the economy and questioned whether monetary policy was the proper tool to address the problem.

"There is a question ... how much impact can you have by affecting the price of interbank lending here when the real problem is that these big institutions and others are afraid to lend to each other, period?" he said in a response to a question from the audience.

He noted that the freezing of credit markets has happened extremely rapidly, and noted a possible shift in inflationary forces as the economy slows. He said businesses were just starting to pass through higher prices to customers.

"To me that was an argument for being very careful about the pace of cutting rates. It's almost as if the world has turned on a dime. This freezing up that we've seen ... is taking place everywhere."

Fisher, in answering media questions, said clogged credit markets were grinding the economy to a virtual standstill -- although he shied away from the term "recession."

"I do think that we will have a period of slow economic growth -- if anything, marginal economic growth -- for a sustained period, into 2009, because the credit markets, which are the lifeblood of capitalism, are closing up," Fisher said.

Fisher cautioned that investors should not panic and said "good investors" know how to take advantage of distressed market situations such as the current one.

"There is a retrenchment from the great excesses we've had," he said. "There is a correction. I don't think it's time to panic."

He added that banks in Texas, where the economy has benefited from strong oil prices, were generally in good financial shape, with balance sheets twice as strong as banks in the nation as a whole. (Editing by James Dalgleish)