Fed says plan now to avert inflation

By Ros Krasny

TULSA, Oklahoma (Reuters) - The United States economy will skid more deeply into recession in coming months, Federal Reserve policy-makers warned on Thursday, but it is time to start planning how to wind down spending to avert an inflationary surge.

The president of the Kansas City Federal Reserve Bank, Thomas Hoenig, said that hard as it was to predict when the winding-down process must be initiated, it will happen.

"We know it has to happen, but the timing I can't tell you. Nobody knows. We will watch every indicator of data that suggests a recovery is on the way," Hoenig said in response to audience questions after a speech in Tulsa, Oklahoma.

"Failure to do that at the right time means you risk a much higher inflation environment," he added.

Hoenig acknowledged the economy remains "under significant stress" from the ongoing banking crisis. But he said the U.S. central bank cannot wait until it is well into recovery and the job market is strong before acting.

The Fed's second longest-serving policy-maker added that he expects resistance "almost immediately" to any move to raise interest rates or, for example, to start selling off its stash of mortgage-backed securities.

Hoenig and a second regional Fed bank president, Gary Stern of Minneapolis, said there were still significant credit strains holding the economy back and cautioned that an eventual rebound likely will be mild.

"The recession is likely to persist for some time longer, and the initial stage of the recovery seems likely to be subdued," Stern said in remarks prepared for the South Dakota economic summit in Sioux Falls.

"In view of the state of the credit markets, it seems a fair bet that it will take time for momentum to build. But ... as we get into the middle of 2010 and beyond, I would expect to see a resumption of healthy growth," he added.

A third speaker, White House Economic Adviser Lawrence Summers, told the Economic Club in Washington that there were "substantial downdrafts" hindering a U.S. recovery. "Economies don't go from losing 600,000 jobs a month to a terribly happy path overnight," he said.

But Summers added that overstocked inventories were being drawn down and "the sense of a ball falling off a table, which is what the economy has felt like since the middle of last fall, I think we can be reasonably confident that that's going to end within the next few months."

Hoenig said getting the banks back into good health was vital for a sustained recovery.

"The restoration of normal financial activity depends on how we deal with the problems of our largest financial institutions," he said, and policy-makers need to be mindful of public dissatisfaction with costly taxpayer-funded bailouts.

Even at larger institutions, "failure does have to be an option in an economic system such as ours," he said, adding that as part of the resolution process, senior management at the failed firms should be replaced.

Summers said there was little choice now but to do everything possible to stimulate economic activity. But he said the Fed must be ready to act decisively in the medium term to restrain spending so that inflation is contained.