Fed officials lean toward no "holiday" rate cut

CHICAGO (Reuters) - Two Federal Reserve Bank officials hinted strongly on Tuesday that they would not support an interest rate cut in December, contending that the Fed has provided enough insurance against financial turmoil and would risk opening the door to higher inflation.

The comments from Chicago Fed President Charles Evans and Philadelphia Fed President Charles Plosser put the central bank at odds with financial markets that are anticipating a series of rate cuts over the next few months.

Many Fed watchers see further easing as a necessity given the almost daily widening of turmoil in global credit markets -- conditions that have worsened even since the most recent Fed policy meeting in late October.

Many see a rising chance of an economic recession in 2008 as falling house prices erode consumer confidence and consumer spending in turn.

But Evans and Plosser, while acknowledging risks to the economy, suggested that further cuts to the federal funds rate, the bank's most powerful policy tool, might not be the right solution to the credit market's problems.

Plosser, known as one of the more hawkish members on inflation among Fed policy-makers, said the Fed cannot eliminate recent market dislocations 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 in a speech to the Rochester University Simon Graduate School of Business.

Plosser will vote on the policy-setting Federal Open Market Committee in 2008.

Evans, an FOMC voting member this year, said the U.S. central bank has probably cut rates enough for now to ward off the chances that growth will be weaker than the Fed already expects.

"While the risk is still present of notably weaker-than-expected overall economic activity, given the policy insurance we have put in place I don't see this as likely," Evans told a Futures Industry Association conference in Chicago.

The balanced risk assessment given by the FOMC at the conclusion of its October policy meeting is still appropriate, Evans said.

"As of today, I feel that the stance of monetary policy is consistent with achieving our dual mandate objectives and will help promote well-functioning financial markets."

Plosser, meanwhile, said cutting rates could do more harm than good at a time when the U.S. economy is facing "significant inflationary pressures" and inflation expectations that are more "fragile" than several months ago.

"Providing insurance through a reduction in the fed funds rate creates its own set of additional risks," Plosser said. "The Fed must be very vigilant," he said.

The Fed has slashed its benchmark federal funds rate target by a cumulative 75 basis points since September, bringing the rate to 4.5 percent.

Expectations for cuts priced by financial markets were trimmed after the two-pronged Plosser-Evans attack. Markets still look for a 25-basis-point cut in December but eliminated an earlier 18 percent chance that the Fed would cut rates by as much as 50 basis points.

The pair "gave little sense that they are looking for an interest rate cut at the next meeting of the FOMC on Dec 11," said Michael Feroli, U.S. economist at JPMorgan Economics.

"Evans has aligned himself close to the center of the committee in his short time as Chicago Fed president, and for that reason his 'stay-the-course' comments were more notable," Feroli said.

Some forecasters this week started to anticipate more aggressive rate cuts by the Fed as perceived risks of recession increase based on recent economic data.

Investment bank Goldman Sachs now looks for rates to be slashed to as low as 3 percent from their earlier forecast of 4 percent, citing an increased probability of recession.

Evans and Plosser, on the other hand, far from calling for a recession, both forecast a rebound in the economy next year.

Evans said consumer spending would likely be supported by solid employment growth and rising wages, even as access to credit becomes more difficult for some Americans, he said.

Plosser 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.

Evans said recent signs on inflation had been "encouraging" but that overly accommodative policy risked reversing the work done by the Fed to cool price pressures.

For now, he said the core personal consumption expenditures (PCE) price index, stripped of food and energy prices, should hold in the 1.5 percent to 2 percent range in 2008 and 2009.

(Additional reporting by Tamawa Kadoya in Rochester, New York; Editing by Leslie Adler)