Fed officials see economic gloom, policy bind

WINONA, Minnesota (Reuters) - Two top Federal Reserve policy-makers painted a gloomy picture on the U.S. economy on Thursday, on a day when initial claims for unemployment assistance topped half a million people.

The Fed has limited room to move as benchmark interest rates creep closer to zero, but it does not face the inflation threat it struggled with earlier this year, they said.

Gary Stern, president of the Minneapolis Fed, said the current U.S. downturn looked similar, but potentially worse, than one in the early 1990s, and growth could be held down by "financial headwinds" for one to three years.

The current shock has become "a good deal more severe" than the 1990s as the bursting of the housing market bubble from earlier this decade has slammed the economy, Stern said in remarks at Winona State University in Minnesota.

"I certainly would make no claim for having foreseen how the decline in housing prices would spill over so aggressively to the financial sector and real economy," he said.

The negative wealth effect felt by many Americans as their housing and investment values decline will continue to suppress consumer spending for now, Stern added.

Speaking at the Economic Club of Pittsburgh, Philadelphia Fed President Charles Plosser said he anticipates a sharper decline in fourth-quarter gross domestic product than the 0.3-percent annual rate of decline logged in the third quarter, and expects the jobless rate to top 7 percent in 2009 versus the current 6.5 percent.

Stern and Plosser are both voting members of the Federal Open Market Committee in 2008, which meets to set U.S. interest rate policy for the final time this year on December 16.

TECHNICAL DIFFICULTIES

Financial markets fully price a one-quarter percentage point cut to the benchmark federal funds rate at the final FOMC meeting for 2008, to 0.75 percent, and assess a strong chance the rate will be slashed all the way to 0.5 percent.

The funds rate has already been cut from 5.25 percent since September 2007 in an attempt to shore up the sagging economy and jump-start credit market activity.

However, Plosser told reporters that technical problems confront the Fed in potentially pushing the rate any lower and he is "comfortable" with rates as they stand.

Cutting the rate below 1 percent creates problems for investors and mutual funds in short-term money markets -- "technical ramifications" that become more complex the closer the rate gets to zero.

"There are a lot of questions we're going to have to grapple with going forward," Plosser said. "You have to think about what this means for policy, market functioning, how we manage reserves."

Stern said with the federal funds rate already at 1 percent, the U.S. central bank would be pushed into a regime of "quantitative easing," or flooding markets with enough liquidity to keep the effective funds rate well below the official target rate.

Many analysts concede that quantitative easing is well under way given a massive increase in the Fed's balance sheet over the past several weeks.

Plosser and Stern both stressed the temporary nature of the Fed's efforts to get credit markets moving, and the need to reverse those moves when conditions allow.

The Fed must be ready to shrink its balance sheet, but that process "might not be easy," Plosser said.

Similarly, Stern said "it will be difficult to unwind" all of the new programs and lending facilities the Fed has put in place since the credit crisis erupted in August 2007, whipped up by the collapse of the U.S. market for subprime mortgages.

There are tentative signs that the Fed's efforts are bearing fruit, including a reduction in the spread between three-month London Interbank Offered Rates and the fed funds rate over the past month, he said.

"We have seen some important progress in recent weeks in funding markets. ... That said, significant strains continue in some markets and among financial institutions."

INFLATION FINALLY ON BACK BURNER

Both policy-makers are renowned inflation hawks, but conceded that with commodity prices in freefall since early July, the inflation threat has passed for now.

Overall and core prices measures, which exclude food and energy costs, are both likely to subside, Stern said.

Plosser said he is now less concerned that inflationary expectations, or ideas of what future inflation will be as interpreted by the marketplace, will become unhinged.

Both policy-makers warned against potential reflexive moves to impose burdensome regulations on markets in the fall-out of the credit crisis.

"Such 'quick fixes' may inadvertently hamper market competition and innovation and create conditions that may provide the foundation of the next crisis," Plosser said.

Stern called for a new, more pro-active approach by the Fed in identifying and taking action on asset price bubbles before they blow up -- even if it means raising interest rates faster than further than might otherwise be the case.

(With additional reporting by Kristina Cooke in Pittsburgh; Editing by Neil Stempleman)