UPDATE 1-Fed's Hoenig says U.S. rates very stimulative

(Adds further comments, background)

By Zelie Pollon

ALBUQUERQUE, Oct 2 (Reuters) - Kansas City Federal Reserve Bank President Thomas Hoenig said on Thursday that U.S. interest rates were very accommodative and the central bank must at some point confront the question of when to move them higher.

"You could leave rates alone or move them up and you still have an accommodative monetary policy," Hoenig said as he took questions after a speech. "I'd rather do that as soon as I can than to just let it sit indefinitely."

Hoenig, who is not a voter this year on the Fed's policy-setting panel, expressed discomfort at high headline inflation, although he said inflation should slow given the retracement in commodity costs and slow economic growth.

"We need to deal with this crisis, I agree, and it's difficult, but we can't lose sight of what's ahead of us," he said, adding that an easy monetary policy helped fuel the credit boom that led to the current crisis.

The Fed lowered benchmark overnight rates from 5.25 percent to a low 2 percent over the seven months ended in April and financial markets now expect the U.S. central bank to lower them again at its next meeting on Oct. 28-29, perhaps by a sizable half-point, to combat a sharp slowdown.

Hoenig acknowledged the U.S. economy was facing a rocky time.

He said he expected growth in the third quarter was "very modest" -- well below the long-term sustainable pace of around 2.75 percent a year -- and said the economy would also be weak in the fourth quarter and into next year.

"But as the financial sector settles out, as the consumer finds a new level of equilibrium, as businesses hopefully gain confidence as we get into next year, we'll see the growth rate begin to improve as well, maybe in the second quarter or second half of next year," he said.

"I'm confident that ... we will see the economy improve slowly over time," Hoenig said.

The Kansas City Fed chief said consumer spending was weakening and that exports would likely flag as well, but he said corporate America was still in good shape to invest, aside from the auto and financial sectors.

He expressed concern not only over the level of headline inflation, which registered a 5.4 percent gain year-on-year in August, but core inflation as well. Excluding food and energy costs, the consumer price index increased 2.5 percent in the 12 months through August.

Hoenig cautioned, however, that any forecast made during the current bout of heightened uncertainty was difficult.

"There's so much uncertainty, there are so many things up in the air, that I'm really cautious about trying to tell you what the economy will look like," he said.

"Obviously, our economy is really going through some very difficult (financial) turmoil," Hoenig said. "It is very serious. I'm very concerned."

But he also said he was confident that a consensus would be reached in Washington on how to respond.

Hoenig said that the choking up of credit markets had blunted the effectiveness of U.S. monetary policy, but that the impact of rate cuts would be felt as confidence returns to financial markets.

He said that was why the Fed was endeavoring to provide liquidity to institutions that need it, drawing a distinction with interest-rate policy.

"It's going to take a little bit of time," Hoenig said. "We have to gain some confidence back into the broader financial markets -- and we will. Once we settle that out, it'll begin to pick up." (Reporting by Zelie Pollon; Writing by Tim Ahmann; Editing by Neil Fullick)