Fed must be ready to take back cuts: Fed's Mishkin

NEW YORK (Reuters) - The Federal Reserve should be ready to reverse two interest rate cuts if the U.S. economy escapes major damage from recent market turmoil, but recovery is a way off for housing and subprime mortgage markets, Fed officials said on Monday.

The Fed's two rate cuts in September and October, which lowered the key federal funds rate three-fourths of a percentage point to 4.5 percent, should buffer the economy from the impact of the turbulence that roiled financial markets over the summer, Fed Governor Frederic Mishkin said on Monday.

Still, policy-makers should be prepared to raise rates if that policy medicine proves unnecessary to prevent inflation from igniting, he added.

"In circumstances when the risk of particularly bad economic outcomes is very real, a central bank may want to buy some insurance and, so to speak, 'get ahead of the curve,'" Mishkin said at a conference on risk management in New York.

"If, in their quest to reduce macroeconomic risk, policy-makers overshoot and ease policy too much, they need to be willing to expeditiously remove at least part of that ease before inflationary pressures become a threat," he added.

The financial turbulence of summer has eased, but stresses remain and markets have not fully recovered, Mishkin said.

COSTS OF FED STASIS TOO HIGH

The most recent rate cut last week by the Fed's Federal Open Market Committee (FOMC) was not a clear-cut choice but was warranted on the grounds that it could be reversed if inflation began to flare, Mishkin said.

"The FOMC perhaps could have waited for more clarity and left policy unchanged last week, but I believe that the potential costs of inaction outweighed the benefits, especially because, should the easing appear to have been unnecessary, it could be removed," he said.

Mishkin said he had been "comforted" before the Fed's October interest-rate setting meeting that there was little direct evidence of serious spillover effects from the housing slump and tighter credit into the broader economy.

In the housing sector, however, signs point to continued struggles, particularly in the subprime mortgage market that caters to borrowers with blemished credit, Fed Governor Randall Kroszner said in a speech in Washington.

"Conditions for subprime borrowers have the potential to get worse before they get better," he said in a speech to the Consumer Bankers Association.

All indications are that housing activity will continue to weaken and that house prices will remain sluggish for some time, Kroszner said. Loan delinquencies and home foreclosures are also likely to rise "for a number of quarters," he said.

Signs emerged on Monday that problems in the housing market are leading to tighter credit standards, even for borrowers with pristine borrowing histories.

A Fed survey of senior loan officers showed large banks broadly tightened credit standards on nearly all types of loans in the past three months, taking a particularly cautious view of prime and "nontraditional" home mortgages.

NO WALL STREET BAILOUT

Addressing criticism that the Fed's rate cuts were shielding some investors and financial institutions who badly underestimated risks associated with subprime mortgages, Mishkin said the Fed rate cuts were aimed at forestalling any damage to the broader economy, not sparing investors from losses. Central bank actions to minimize the impact of financial instability are "designed to help Main Street and not bail out Wall Street," he said.

At the same time, policy-makers have not put to rest worries that developments such as climbing oil costs, the weaker dollar, and the tight labor market have the potential to push prices higher, Mishkin cautioned.

"Even if readings on core inflation have improved modestly this year, recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation," he said.

Policy-makers monitor asset prices, including the value of the dollar, because of their potential effects on inflation, Mishkin said. He played down the impact on inflation of the weaker dollar, which he said makes importing goods more expensive.

"The numbers here are not as huge as some of the doomsdayers (say)," he said in response to questions after his speech.

(Additional reporting by Joanne Morrison and Glenn Somerville; Writing by Mark Felsenthal; Editing by Jonathan Oatis)