Fed's Poole warns Fed must not ignore inflation

KIRKSVILLE, Missouri (Reuters) - The economy will probably avoid a recession but inflation is also a risk and the Federal Reserve must not ignore this threat as it battles weak growth, one of the Fed's top policy-makers said on Wednesday.

"At any given time, policy-makers could pursue a powerfully expansionary policy to all but eliminate the possibility of a significant recession in the year ahead but doing so would come at the cost and even likelihood of an unacceptable increase in the rate of inflation," St. Louis Federal Reserve Bank President William Poole said at Truman State University.

"A substantial increase in the rate of inflation promises a larger recession later, as the country learned at such great cost in the 1970s," he said in a speech.

Poole retires at the end of March and will not take part in the Fed's policy meeting on March 18 as a member of the Federal Open Market Committee, which sets U.S. monetary policy.

Investors expect the U.S. central bank to lower benchmark interest rates again to shield the economy from severe problems in the housing market that have sparked a credit crunch.

The Fed already has cut rates by 2.25 percentage points since mid-September.

Poole acknowledged the economy was soft, but said it would duck a recession.

"The U.S. economy today is limping along. Some believe recession is at hand; others, and I include myself in this group, believe the economy will skirt recession," said Poole.

"The difference in view may not be very large, as an economy growing at a barely positive rate will look and feel about the same as one with output falling slightly," he added.

The Fed on Wednesday lowered its growth forecast for 2008, while slightly raising its inflation forecasts.

The growth forecast was cut to between 1.3 and 2 percent from 1.8 to 2.5 percent, while predictions for the price index for core personal consumption expenditures rose to a range of 2 to 2.2 percent from 1.7 to 1.9 percent.

Poole said there was widespread concern about unemployment but warned that inflation should not be ignored. The St. Louis Fed chief later told reporters the rise in consumer prices seen in January was unwelcome but that it was no reason for alarm.

"It is going in the wrong direction ... but it is creeping in the wrong direction, not galloping," he said.

"I think it is something that the FOMC has to watch, but I am not alarmed," he said.

January CPI advanced by 0.4 percent overall while the core number, excluding food and energy prices, rose 0.3 percent.

Poole indicated in his speech that inflation expectations, which he stressed were the key to keeping inflation well anchored, remained stable.

"We can conclude that the current situation is one of substantial stability of inflation expectations," he said.

"Recent relatively small increases in inflation are apparently due to transitory factors and not to changes in inflation expectations."

On the other hand, Poole noted that the divergence between core and headline measures of the consumer price index might be a problem for policy-makers.

"It is not unreasonable to forecast that increased demand for food and energy by emerging economies with large populations will continue for a considerable period," he said.

"This possibility suggests the FOMC must exercise caution lest monetary policy inadvertently accommodates an increased inflation trend by focusing on the behavior of price indexes excluding food and energy," Poole added.

In responses to questions from the audience, Poole said monetary policy was not aimed at supporting a certain sector of the economy or at currency rates.

While the new home construction sector was "in depression," he said: "We have to be careful that we have a monetary policy that is for the entire economy and we can't allow five percent of the economy to so dominate the monetary policy outcome that we forget about the other 95 percent of the economy."

On exchange rates, he said recent weakness in the dollar has helped reduce the U.S. trade deficit and boost exports. "So we watch (exchange rates) but in no way do we try to adjust policy to create a particular outcome."

(Additional reporting by Tamawa Kadoya in New York; Editing by James Dalgleish)