Fed's Hoenig: Challenge is to keep inflation at bay

By David Lawder

OKLAHOMA CITY (Reuters) - The U.S. Federal Reserve will have to focus squarely on containing worrisome inflation as financial markets return to normal while tax rebates and interest-rate cuts begin to aid the economy, Kansas City Fed President Thomas Hoenig said on Tuesday.

"We have had this financial crisis; I think on balance as we at the Federal Reserve have provided liquidity to the marketplace, it's my thought that we have stabilized things," he said in remarks to the Rotary Club here.

"This allows the other policy choices, the tax cut ..., monetary policy that's in place, to strengthen the economy as it goes through the course of the year," he said. "And in that context then, our big challenge will be to make sure that we bring inflation in check and make sure that we do not repeat some of the experiences we had in the late 70s and early 80s when inflation became far too high," he said.

Hoenig repeated concerns about inflation voiced last week, saying it has increased "at what I call unacceptable levels. Energy, food and other commodities have simply soared."

He said some analysts believe that prices will cool and retreat as demand slows, but added that may be a longer-term phenomenon. In the meantime, he is worried that inflationary expectations are building as they did in the 1970s.

"I think there's a real danger of, in fact that with this inflation, that the psychology around inflation is beginning to change, expectations of inflation are beginning to change, and that, I think, is a major concern to me.

"Once people start passing this on, start thinking about inflation as a way of life, behaviors change," he said, adding that contracts for major construction projects could start to have built-in price escalators and that investment decisions change.

Hoenig also noted that steep oil prices have taken their toll on the U.S. economy, erasing at least one full percentage point from U.S. economic growth.

"We estimate ... that every $10 increase in the cost of a barrel of oil reduces the real GDP somewhere between two-tenths and perhaps as much as a half a percentage point," Hoenig said.

"At a conservative level, that means that we have taken at least another percentage point off on a national scale in terms of real gross domestic product," he said.

Hoenig said the U.S. economy faced a difficult set of circumstances because of high oil prices, the housing downturn and subsequent credit contraction, but growth should pick up later this year as accommodative monetary policy starts to take effect. Tax rebates also will boost spending, but this effect could be temporary, he said.

He said the Fed faces a "major challenge" in deciding when to change its policy stance as the economy begins to strengthen. He said the Fed must "make sure that we don't allow inflation to worsen over the course of the year as well."

(Additional reporting by Emily Kaiser and Mark Felsenthal. Editing by Chizu Nomiyama)