Fed's Lacker says further rate cuts quite possible

RICHMOND, Virginia (Reuters) - Weaker U.S. growth means more interest rate cuts are "quite possible" but policy-makers cannot ignore inflation, a top Federal Reserve official said on Friday, reinforcing hopes of another easing later this month.

"A slowing economy requires lower real interest rates because it means a softer relative demand for resources now compared to the future," Federal Reserve Bank of Richmond President Jeffrey Lacker said in a speech.

"And the current downside risks mean that further slowing, and thus further easing, is quite possible. But inflation also presents risks," he told the Risk Management Association of Richmond.

It was a major shift in tone for one of the Fed's arch hawks, who dissented from the majority and voted repeatedly to raise rates in 2006 and who had been emphasizing inflation risks over the growth outlook as recently as last month.

Lacker said that his opinion had been altered by the weak December employment report, when just 18,000 new jobs were created, softer manufacturing data and anecdotal soundings that point to softness in commercial real estate.

"The incoming data arriving in the last several weeks has certainly made me more willing to contemplate rate cuts. It has certainly altered the outlook," he told reporters.

On inflation, he made plain that it could be put aside as a concern in the very short term, while the Fed tackles weaker growth, but has to remain on the radar screen.

"Inflation is still higher than I would like to see it personally ... I just don't think it is a sensible strategy to put our inflation objectives on the shelf for the duration."

In response to audience questions, Lacker noted that one of the influences on rising prices was the dollar's declining value against other major currencies, which makes everything from imported oil to consumer goods more costly.

"The falling value of the dollar externally obviously provides some impetus to inflation domestically through input prices," he said. The dollar has lost value amid concerns about U.S. economic prospects and because investors foresee U.S. interest rates declining.

The Fed has cut interest rates by a full percentage point since mid-September to protect the U.S. economy from a slumping housing market and global credit crunch.

Lacker's comments bolster investors' expectations that the Fed will cut the benchmark overnight rates by a further 50 basis points at its next meeting on January 29-30.

OVERSHOOT RISK

However, his remarks on inflation betrayed concern that the Fed might push borrowing costs too low, and then have a hard time bringing them back up quickly as growth gathers pace.

Critics concerned about price pressures say that raising rates could be very hard. They worry that the Fed might need to start tightening while unemployment was still high, creating a political firestorm if this fell before the November U.S. presidential election. Lacker acknowledged the problem.

"In the past it has been difficult to reverse field quickly when warranted," he said in response to a question on whether the Fed might overshoot and cut rates too far.

He also made the point that people should be realistic in their expectations for what either monetary or fiscal policy can accomplish in the face of the current economic weakness.

"This does seem like a slowdown that hasn't been that preventable," he said.

"What we are going to see this year ... (is) going to be difficult to counteract ... It would be useful not to be too optimistic," he said, when asked for his views on the prudence of a government fiscal stimulus package.

President George W. Bush has asked Congress to back a $150 billion package of temporary tax cuts and other measures to give the economy a "shot in the arm".

Many fear the country risks tipping into a recession without emergency action. Lacker said he had trimmed his growth forecast, but still expects the economy to expand, albeit at a slower pace.

"The economic outlook for 2008 has worsened in response to the developments of the last six months, and the recent flow of data has heightened the downside risks," he said in the speech, adding that housing would likely not bottom out this year.

"I expect growth to be very weak for several more months, but to improve toward the end of this year. Clearly, the most cogent risks to growth are on the downside," he said.

(Additional reporting by Emily Kaiser and Glenn Somerville, editing by Tom Hals)