Fed's Plosser says rate cuts risk higher inflation

ROCHESTER, New York (Reuters) - Philadelphia Federal Reserve Bank President Charles Plosser said on Tuesday lowering interest rates could do more harm than good at a time when the U.S. economy is facing "significant inflationary pressures."

"In the current environment, providing insurance through a reduction in the fed funds rate creates its own set of additional risks," he said in a speech to the Rochester University Simon Graduate School of Business.

"A lower funds rate creates a risk that inflation may be exacerbated and inflationary expectations may begin to rise."

The Fed has lowered its benchmark federal funds rate target by a cumulative 75 basis points since September. Investors expect another cut when the Fed holds a rate-setting meeting on December 11.

Plosser, known as one of the more hawkish members on inflation among Fed policy-makers, will become a voting member of the Federal Open Market Committee next year.

In a question-and-answer session, Plosser said the uncertainty about the economy was increasing.

He also said a weaker dollar would help reduce the massive U.S. current account deficit. "So there are some good things about the dollar declining but we have to see how it unfolds," he said.

In the speech, Plosser reiterated he would not change his economic outlook or his view on interest rates unless merited by significantly weaker economic data.

In a New York Times interview earlier this month, Plosser said he would not be surprised if U.S. economic growth slowed in the fourth-quarter to 1 percent to 1.5 percent, and that growth would have to be less than that for him to consider cutting rates again.

In the speech, Plosser said the Fed could not eliminate recent market turmoil caused by investors reassessing the value of financial instruments.

"In some circumstances, lowering interest rates may prolong the painful process of price discovery," he said.

He also said an upward revision to the economic outlook would warrant discussion of what the appropriate fed funds rate should be.

ECONOMY TO PICK UP

Plosser said he expected the decline in housing activity would bottom out by the end of the second quarter next year.

Overall, real economic growth would be faster in the second half of 2008 as it returns to the long-term trend of about 2-3/4 percent, he said.

On a fourth-quarter to fourth-quarter basis, he said he expects the economy to grow about 2.5 percent in 2008, putting him at the highest end of the forecast range by FOMC members released last week.

Below-trend growth would mean the unemployment rate may rise "to about 5 percent" next year, although that was still at a historically low level, he said. The jobless rate has hovered around 4.7 percent recently.

On inflation, data since early spring showed core inflation rates that exclude food and energy prices have been stable and inflation expectations were fairly well anchored, he said.

"While I did not, and do not, take this as evidence that inflation is no longer a risk, it is encouraging," he said.

However, inflation expectations were more fragile compared with four to six month ago, and the rise in oil and commodities prices suggest that "significant inflationary pressures exist" in the economy, he said.

"The Fed must be very vigilant."

On the other hand, Plosser cited downside risks to the economy as a more prolonged housing downturn, financial problems leading to a more significant spillover into the economy, and high oil and commodity prices restrain both consumer and business spending.

The Fed's decision to release quarterly and more detailed economic projections was a "major step" in making the central bank's outlook and policy deliberations more clear to the public and markets, Plosser said.

He reiterated his stance that the U.S. central bank should adopt an explicit price target to stabilize inflation expectations.

He also warned against investors being too short-sighted.

"Too often people seem to think that when a weak economic number is released, the Fed will respond to it immediately with a policy action," he said.

"In my view, if the FOMC members already expected some bad economic numbers and had already taken those into account in their outlooks when they set the fed funds rate target, then you should only see policy-makers take action when the outlook changes significantly -- not on a few bits and pieces of news."

(Additional reporting by Pedro da Costa; Editing by Tom Hals)