Fed should resist rate cut calls, Fed's Warsh says

WASHINGTON (Reuters) - The Federal Reserve must protect its inflation-fighting credibility and should resist "reflexive" calls to cut interest rates further if growth weakens, a top Fed policy-maker said on Wednesday.

Fed Governor Kevin Warsh said the U.S. central bank had lowered rates considerably to offset the shock of the housing crisis, and it was now time for the private sector to continue the healing process.

"Even if the economy were to weaken somewhat further, we should be inclined to resist expected, reflexive calls to trot out the (interest rate) hammer again," he told the Exchequer Club in Washington.

The Fed has slashed interest rates by 3.25 percentage points since mid-September to shield the economy from a global credit crunch sparked by the meltdown of the U.S. subprime mortgage market. Investors see it holding rates steady until toward the end of the year, and then starting to raise them.

Warsh's remarks will reinforce this perception, as well as the view that the Fed is ramping up its inflation rhetoric. His speech follows similarly hawkish comments this week from Fed Vice Chairman Donald Kohn.

"Private financial institutions should raise substantial capital, reconstitute business models, and take other actions to reinvigorate the principal transmission mechanism of monetary policy," he said.

Warsh said inflation should moderate gradually if soaring commodity prices level out, as expected. He also noted wages were not likely to accelerate and core inflation, excluding energy and food prices, was in a "seeming steady state."

But he was adamant that the central bank could take no chances with its anti-inflation reputation.

"Inflation has been elevated for some time and prices of commodities are surging. I find these trends particularly vexing at a time when global demand growth, most likely, has slowed," he said.

"If the Fed were deemed too accommodative for too long, credibility could be undermined, threatening to create a persistent inflation problem that would have to be corrected, no doubt at great cost.

"The public could see the stance of policy as a sign that our commitment to long-term price stability has wavered. That is not a perception we will countenance," he said.

In addition to aggressive rate cuts the Fed has also created several new tools to pump liquidity in markets that threatened to seize up amid panic over subprime-linked losses.

Warsh said its Term Auction Facility in particular seemed to be doing its job of keeping capital flowing to borrowers outside of the traumatized financial services industry.

"Many parts of the real economy are still getting access to capital, access to credit. That is essential ... that capital is available far outside of Wall Street," Warsh said in response to a question.

He also made plain in the speech that there was a limit to what could be expected of monetary policy.

"Increasing liquidity by having a central bank lower the federal funds rate can reduce the risk of more severe financial crisis, but is imperfectly suited to compensate for declines in liquidity arising from retrenchment in the financial sector."

(Reporting by Joanne Morrison, writing by Alister Bull; editing by Neil Stempleman)