Fed wrestles with growth and inflation worries

By Steven C. Johnson

NEW YORK (Reuters) - Federal Reserve officials on Wednesday expressed concern about a possible U.S. recession but warned that the central bank cannot let down its guard when it comes to fighting inflation.

"Right now, we're concerned about growth," Richmond Federal Reserve Bank President Jeffrey Lacker told students and faculty at Marshall University's Lewis College of Business in Huntington, West Virginia.

While inflation risks have risen over the past six to eight weeks, the economy will manage to grow at a sluggish rate of about 0.5 percent in the first half of the year, Lacker said.

Since September, the Fed has cut benchmark interest rates by 2.25 percentage points to 3 percent to help the economy weather a deep housing slump and a global credit crunch.

Philadelphia Fed President Charles Plosser said in a speech to the Rotary Club of Birmingham, Alabama, the Fed's aggressive rate cuts will help the economy to return to trend growth of around 2.7 percent by 2009, though he predicted sluggish growth in the first half of 2008.

He did not forecast a recession but told reporters after his speech that "if something can tip us into recession, the housing market is the biggest risk."

The stock market fell late on Wednesday as the comments by the Fed policy-makers cast doubt on the outlook for more interest rate cuts. The Dow Jones industrial average closed down nearly 65 points. U.S. government debt prices also fell.

Both men said slower growth does not mean the Fed can take its eye of the ball when it comes to inflation.

"We cannot be confident that a slow-growing economy in early 2008 will by itself reduce inflation," Plosser said.

He said he expects core inflation, which strips out volatile food and energy costs, to remain above 2 percent, "which is above the range I consider to be consistent with price stability."

Lacker also said it was worrisome to see inflation at current levels. The overall consumer price index rose 4.1 percent in the 12 months to December, while the core rate, which excludes energy and food, climbed 2.4 percent.

"We can't cut interest rates as aggressively in response to weakness in growth as we otherwise would," Lacker said. "We're going to be posed with some problems this year if inflation doesn't moderate the way we'd like to see it moderate."

Lacker is not a voting member of the central banks' rate-setting Federal Open Market Committee this year. However, Plosser is a voter, and he endorsed a half percentage point cut to the federal funds rate at the last policy meeting on January 30.

FUTURE RATE CUTS

Lacker did say, though, that it's possible the Fed will have to trim interest rates further to deal with weakening output in the world's largest economy.