Fed's Lockhart urges patience amid strained markets

ATLANTA (Reuters) - The Federal Reserve must be "very vigilant" amid strained financial markets while exercising patience over interest rates as it waits for inflation to ease, a top Fed policy-maker said on Wednesday.

"I am comfortable with the current policy. I believe we need to give the second half (of 2008) a little time, to see if the scenario that I personally am counting on plays out more or less according to plan," Atlanta Federal Reserve President Dennis Lockhart told reporters after a speech at an economics conference hosted by Georgia State University.

In the speech, he said inflation was expected to moderate from current uncomfortably high levels, thanks in part to recent declines in the cost of oil. Still, he was cautious about the outlook for the economy overall.

"Many markets continue to be strained ... It seems to me that we have to continue to be very vigilant about the status of the financial markets, and their potential negative impact on the general economy," he told reporters.

This references a vicious downward spiral involving losses related to U.S. real estate and tighter credit conditions as banks curtail lending, which in turn makes it harder for people to buy homes and aggravates mortgage losses further.

The Fed has slashed interest rates 3.25 percentage points to 2 percent since mid-September to offset the situation. It halted that rate cut campaign earlier this year and is now expected to stay on hold until 2009.

Lockhart, a former banker who will be a voting member of the U.S. central bank's interest rate-setting committee next year, said that the fallout from the housing collapse and credit crunch had not subsided.

"The banking system is experiencing a lot of strain and some banks are in very difficult circumstances...we continue to monitor banks in this particular part of the country and a number of them are facing liquidity strains and asset quality strains," he said

Economists think that worry about weakening economic growth and fragile markets will keep Fed rates unchanged despite high inflation amid soaring energy and fuel prices. Lockhart backed this view, stressing that price pressures ought be temporary.

"With weak growth and financial market strains, I believe the most likely outcome is that both headline and core inflation will diminish over the rest of 2008 and into next year as the temporary effects of energy and food price increases abate," he said in the speech.

He also said inflation pressures would be helped by the recent decline in oil prices and stabilization of the dollar.

"I think the stabilization of the dollar - which we hope will hold - the stabilization has helped and ... the inter-play between the dollar and commodity prices might also have an influence on the dampening of those pressures," he told reporters.

"The almost $30 drop (in oil prices) has certainly helped, and we believe (it) will play through to the headline inflation number in the second half (of 2008)," he said.

Lockhart stressed that inflation expectations, although very important, had still not deteriorated badly despite soaring costs for energy and food.

"If overall prices do not moderate in the near term as I expect, inflation expectations could become unmoored," he warned. "Inflation expectations may have risen modestly - but not by a material degree."

But he said that keeping expectations under control was crucial in navigating the U.S. economy through its current weak patch, and he made plain he was ready to raise interest rates if there was evidence they were becoming unstuck.

"Let me emphasize that I am mindful of today's elevated risks and am prepared at any point to change tactics to ensure inflation expectations do not become unanchored," he said.

(Reporting by Alister Bull; Editing by Chizu Nomiyama)