Fed must be ready to take back cuts: Fed's Mishkin

By Tamawa Kadoya

NEW YORK (Reuters) - The Federal Reserve should be ready to reverse two interest rate cuts if the U.S. economy escapes major damage from recent market turmoil, but recovery is a way off for housing and subprime mortgage markets, Fed officials said on Monday.

The Fed's two rate cuts in September and October, which lowered the key federal funds rate three-fourths of a percentage point to 4.5 percent, should buffer the economy from the impact of the turbulence that roiled financial markets over the summer, Fed Governor Frederic Mishkin said on Monday.

Still, policy-makers should be prepared to raise rates if that policy medicine proves unnecessary to prevent inflation from igniting, he added.

"In circumstances when the risk of particularly bad economic outcomes is very real, a central bank may want to buy some insurance and, so to speak, 'get ahead of the curve,'" Mishkin said at a conference on risk management in New York.

"If, in their quest to reduce macroeconomic risk, policy-makers overshoot and ease policy too much, they need to be willing to expeditiously remove at least part of that ease before inflationary pressures become a threat," he added.

The financial turbulence of summer has eased, but stresses remain and markets have not fully recovered, Mishkin said.

COSTS OF FED STASIS TOO HIGH

The most recent rate cut last week by the Fed's Federal Open Market Committee (FOMC) was not a clear-cut choice but was warranted on the grounds that it could be reversed if inflation began to flare, Mishkin said.

"The FOMC perhaps could have waited for more clarity and left policy unchanged last week, but I believe that the potential costs of inaction outweighed the benefits, especially because, should the easing appear to have been unnecessary, it could be removed," he said.

Mishkin said he had been "comforted" before the Fed's October interest-rate setting meeting that there was little direct evidence of serious spillover effects from the housing slump and tighter credit into the broader economy.

In the housing sector, however, signs point to continued struggles, particularly in the subprime mortgage market that caters to borrowers with blemished credit, Fed Governor Randall Kroszner said in a speech in Washington.

"Conditions for subprime borrowers have the potential to get worse before they get better," he said in a speech to the Consumer Bankers Association.

All indications are that housing activity will continue to weaken and that house prices will remain sluggish for some time, Kroszner said. Loan delinquencies and home foreclosures are also likely to rise "for a number of quarters," he said.

Signs emerged on Monday that problems in the housing market are leading to tighter credit standards, even for borrowers with pristine borrowing histories.

A Fed survey of senior loan officers showed large banks broadly tightened credit standards on nearly all types of loans in the past three months, taking a particularly cautious view of prime and "nontraditional" home mortgages.