Fed's Mishkin says credit a major drag on economy

By Pedro Nicolaci da Costa

NEW YORK (Reuters) - Struggling credit markets and financial innovation gone awry have become a major drag on U.S. economic growth, Federal Reserve Board Governor Frederic Mishkin said on Thursday.

Many concerns of the banking sector have been all but paralyzed over the last nine months, a development many believe is pushing the United States into recession.

While Mishkin did not weigh in on the recession debate, he acknowledged the negative effects from finance and housing on the real economy.

"This financial disruption has a very contractionary effect," Mishkin told an audience at the Princeton Club in New York.

He said the Fed was right to act aggressively to prevent the financial crisis from hurting growth further, but that monetary policy could not do everything and that severe shocks also require the help of fiscal measures.

Congress has already passed a $168 billion economic "stimulus" package, and is debating more aggressive steps to stem foreclosures on homeowners struggling with high payments.

Still, the troubles in financial markets should not prompt the Fed to let down its guard in the fight against inflation, Mishkin said.

He reiterated a preference for explicit inflation objectives that help guide the policy debate and anchor public expectations about price increases.

"The firm commitment to an explicit numerical inflation objective contributes to better outcomes for both inflation and economic growth," he said.

The Fed governor said central banks that set inflation targets achieve better outcomes for both economic activity and inflation. This holds lessons for the Fed because the U.S. central bank is in the process of refining its policy framework and its communications policies, he said.

Inflation targeting has been criticized by some influential lawmakers who fear an undue focus on prices may detract from the Fed's parallel goal of fostering stable economic growth and low unemployment.

(Reporting by Pedro Nicolaci da Costa and Mark Felsenthal; Editing by Leslie Adler)