Fed's Hoenig: Don't wait too long to raise rates

DURANGO, Colo. (Reuters) - The Federal Reserve must not wait too long before raising interest rates or it risks a serious problem with inflation, one of its top policy-makers said on Wednesday.

"While the current accommodative stance of monetary policy reduces the risk of recession, it almost certainly raises the risk of higher inflation," said Thomas Hoenig, president of the Federal Reserve Bank of Kansas City.

"It will be important for the Federal Reserve to monitor inflation developments and inflation expectations closely, and to move to a less accommodative stance in a timely fashion," he said in remarks prepared for delivery to an audience of business leaders.

"When to begin this process, and how fast to move, will be difficult decisions for the Federal Open Market Committee," he said, referring to the Fed's interest-rate-setting committee. Hoenig is not a voting member of the FOMC this year.

"While a 2 percent federal funds rate may be appropriate in a period of extreme economic weakness, if maintained for too long it could allow inflationary pressures to build over time," he said.

The Fed last month paused an aggressive rate-cut campaign begun last September and left its key overnight benchmark funds rate at 2 percent, warning at the time that inflation risks have mounted even as risks to the economy from a housing crisis remain serious.

Since then, stock markets have been battered by worries over the banking sector and the health of government-sponsored mortgage finance giants Fannie Mae (FNM.N) and Freddie Mac (FRE.N) on fears of home loan losses.

Hoenig acknowledged that problems in the banking sector were making it harder to get credit and this was a restraint on growth, which he expected to be only subdued -- but still positive -- over the rest of 2008.

"While I believe we can avoid a recession, I recognize that there are significant risks that growth could turn out weaker than I suggest here," he said.

This has created a "fine line" for the Fed to walk between sheltering growth and keeping inflation at bay amid soaring energy and food prices. Hoenig, generally counted among the more hawkish Fed policy-makers, made plain that he erred more toward fighting inflation.

"If an inflation psychology becomes embedded in household and business behavior, this current rise in food and energy prices could lead to a much more persistent inflation problem," he said.

June U.S. inflation rose sharply, according to government data released earlier on Friday, with the headline consumer price index up 1.1 percent over the month and standing 5 percent higher than a year ago.

"For me, over 4 percent year-over-year CPI and over 3 percent personal consumption index (PCE), is too high," he said. "I want the CPI or the PCE to come back down, either one or both, back toward in total the 2 percent or less range."

The PCE index is the Fed's preferred measure of prices facing U.S. consumers. It rose 3.1 percent in May versus a year ago.

One factor providing some support to U.S. growth has been stronger exports, helped in part by the weaker dollar. Hoenig said there were several reasons for the currency's softness on foreign exchange markets but it would rebound as the economy recovers.

"Number one, we're running a very substantial current account deficit," he said.

"This country over the last few years has consumed more goods than it has produced ... and to do that we spend our dollars but we have to borrow them back," he told the audience in response to a question after his speech.

"That means other people have to want our dollars and as you accumulate more and more of the deficit, there is a tendency for them (foreign investors) ... to pay not quite so much for (the dollars)," he said.

"Second (point) is that our economy has slowed, so that the opportunities from their perspective ... makes us not as attractive (a place) to invest those dollars.

"When the economy picks up and as we improve our current account -- and we are improving our current account deficit -- then you begin to rebalance your economy, and your currency will reflect that," Hoeing said.

(Editing by Chizu Nomiyama)