Fed's Hoenig: Don't wait too long to raise rates

By Alister Bull

DURANGO, Colo. (Reuters) - The Federal Reserve must not wait too long before raising interest rates or it risks a serious problem with inflation, one of its top policy-makers said on Wednesday.

"While the current accommodative stance of monetary policy reduces the risk of recession, it almost certainly raises the risk of higher inflation," said Thomas Hoenig, president of the Federal Reserve Bank of Kansas City.

"It will be important for the Federal Reserve to monitor inflation developments and inflation expectations closely, and to move to a less accommodative stance in a timely fashion," he said in remarks prepared for delivery to an audience of business leaders.

"When to begin this process, and how fast to move, will be difficult decisions for the Federal Open Market Committee," he said, referring to the Fed's interest-rate-setting committee. Hoenig is not a voting member of the FOMC this year.

"While a 2 percent federal funds rate may be appropriate in a period of extreme economic weakness, if maintained for too long it could allow inflationary pressures to build over time," he said.

The Fed last month paused an aggressive rate-cut campaign begun last September and left its key overnight benchmark funds rate at 2 percent, warning at the time that inflation risks have mounted even as risks to the economy from a housing crisis remain serious.

Since then, stock markets have been battered by worries over the banking sector and the health of government-sponsored mortgage finance giants Fannie Mae (FNM.N: Quote, Profile, Research, Stock Buzz) and Freddie Mac (FRE.N: Quote, Profile, Research, Stock Buzz) on fears of home loan losses.

Hoenig acknowledged that problems in the banking sector were making it harder to get credit and this was a restraint on growth, which he expected to be only subdued -- but still positive -- over the rest of 2008.