Economy on track despite housing: Fed officials

RICHMOND, Virginia (Reuters) - Problems in the U.S. subprime mortgage market should not spread and the main risk remains inflation, top Federal Reserve policy-makers said on Thursday in remarks signaling no interest rate cut soon.

"In the last three to six months the downside risks have definitely crept up. At the same time ... the longer we go on without a noteworthy decline in inflation, the more the risk we run of entrenching expectations where they are now," Richmond Federal Reserve Bank President Jeffrey Lacker told reporters.

Lacker, not a voter on the Fed's policy-setting committee this year, said some people who want to buy houses may be forced to rent instead as a result of rising delinquencies in the subprime market for borrowers with risky credit. But this should not cast a shadow over the wider economy.

"I don't see it as a big risk to growth or housing," he said, echoing what Fed Chairman Ben Bernanke said on Wednesday, as well as Minneapolis Fed chief Gary Stern, who gave a speech on Thursday.

The United States enjoys "a flexible, resilient economy demonstrably capable of sustained economic growth even in the face of disruptions," Stern told a University of Dayton investment forum.

"To be sure, the housing sector has been a drag on activity and is of concern but I suspect that the bulk, although not all, of the adjustment in residential construction is behind us," he said.

"The subprime market is just a fraction of the overall market. It is not big enough to become a major impact on a $13 trillion economy."

Stern, not a voter this year, also said the Fed must remain committed to keeping inflation low, especially as a probable future slowdown in work-force growth raises the potential for higher wages.

"I would not expect inflation to accelerate even if compensation does, as long as the Federal Reserve remains committed to a stable, low inflation policy," Stern said.

MURKY

The Fed last week left interest rates unchanged at 5.25 percent and stressed inflation remained its predominant concern. But it also removed an explicit reference to future interest rate hikes, which Bernanke explained on Wednesday was to buy flexibility in case the economy softened unexpectedly.

Business spending is one potential source of weakness after several months of disappointing durable goods orders, and Lacker confessed it was hard to pinpoint what was going on with capital investment.

"The business investment outlook remains murky. The fundamentals, in terms of cash flow and cost of capital and so on still look favorable."

"Fundamentally, the economy looks sound. But at some microeconomic level, capital spending plans are just not coming together and looking attractive enough at the rate they were, so for some reason capital spending flattened out in the last half year and I think that is a bit of a puzzle," he said.

Financial markets expect steady rates from the Fed when it next meets on policy in May and are pricing a rate cut in the third quarter.

But Lacker, seen as one of the most hawkish policy-makers after he dissented four times last year in favor of higher interest rates when the Fed held benchmark rates steady, did not endorse this presumption.

He said business investment should reassert itself over the course of the year, together with a recovery in the housing sector as the inventory of unsold homes was worked off.

This would clear the path to stronger growth, and raise the issue of whether current interest rates will be high enough to bring inflation down at a fast-enough pace.

"The question in that regard will arise later in the year if, as I anticipate, the downside risks ease significantly.

"I think at that point there will be a policy question in front of us about inflation. Because if inflation has not moderated by then and the downside risks ease and we get by the housing (slowdown), then the choice is going to face us squarely," he said.

(Additional reporting by Ros Krasny in Dayton and Mark Felsenthal in Washington)