Fed's Lacker: Raise rates as growth risks fade

By Alister Bull

WASHINGTON (Reuters) - It makes "eminent sense" to raise interest rates as risks to the U.S. economy recede amid high inflation and the central bank should not wait too long, a top Federal Reserve policy-maker said on Tuesday.

"Just as easing policy aggressively in response to emerging downside risks made sense, withdrawing some of that stimulus as those risks diminish makes eminent sense as well," said Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, Virginia.

Lacker, who will be a voter on the U.S. central bank's interest-rate-setting committee in 2009, said growth would be tepid this year and only pick up gradually next year.

"While the risk of an acute near-term downturn has not entirely disappeared, it has diminished substantially," he said in remarks to a National Economists Club luncheon that echoed a speech he made in June in South Carolina.

Asked by the audience about the timing of rate hikes, Lacker urged that policy-makers not make the error of standing pat until the evidence of a recovery was beyond doubt; a nod to concerns that by such time, inflation will have taken root.

"It is tempting to wait for a fair amount of certainty about the diminution of downside risks to growth. But it is easy to make the mistake of waiting too long," he said.

The interest rate futures market implies that investors fully expect the Fed will have raised interest rates a quarter-percentage point by the time of their meeting in late October. Fed rates are currently at 2 percent.

Lacker also stressed that inflation was already too high, noting the sense that this had yet to spark a U.S. wage-price spiral was no grounds for complacency.

"Maintaining credibility depends on continuing to conduct policy in a way that is consistent with the stability of inflation expectations, and acting forcefully should those expectations erode," he said in the speech.

The Fed last month halted an aggressive interest rate-cutting campaign that had seen it slash the benchmark overnight fed funds rate from 5.25 percent since September to shield the economy from a housing market collapse.

In holding rates unchanged, it argued that inflation risks had grown.

One somewhat unstated reason that analysts think the Fed halted rate cuts was also the depreciating dollar, which has slipped to record lows against other major currencies this year while the Fed was easing monetary policy aggressively. Lacker confirmed the dollar had been on his mind.

"I do see weakness in the dollar as potentially contributing to inflation pressures through its effect on import prices," he told reporters after the speech.

Investors believe the Fed's next policy move will be upward but are split over the timing of any rate hike. This partly reflects divisions among policy-makers, with some more concerned about inflation than others who worry about growth.

Lacker, one of the most hawkish of Fed policy-makers who dissented repeatedly when he was a voter in 2006 in favor of raising rates further, still falls clearly into this camp.