ST. LOUIS The Federal Reserve should not cut interest rates again to cushion the economy from financial market turmoil, a top Fed policy-maker said on Monday, saying that cuts would be ineffective and could compound inflation.
"I don't think lowering rates is the right tool for this environment," St Louis Federal Reserve President James Bullard told Reuters in an interview.
Interest rate futures currently imply that the Fed will impose an emergency half percentage point rate cut, to 1.5 percent, before its next scheduled policy meeting on October 28-29. Bullard said a cut would not help, and might hurt.
"My experience is, you're in the middle of this much volatility, this much turmoil. You lower rates. I don't think it has very much effect," he said.
"(The) stock market is down sharply. Suppose it goes up sharply. What are you going to do? Raise rates again? That doesn't make sense," he said.
He said that Fed interest rates were already as stimulative for growth as they have been in real, inflation-adjusted terms, since the 1970s, and this would stoke price pressures.
"When you're trying to solve one problem, you don't want to create a new problem and compound the situation. I think that that is what happened in the 1970s," he said, referring to period of soaring U.S. inflation that was costly to reverse.
It was the second time in less than a week that Bullard, who is not a voting member of the Fed's interest-rate setting committee this year, had warned that the U.S. central bank should not cut rates again.
He acknowledged on Monday that the panic unleashed by the collapse of U.S. investment bank Lehman Brothers LEHMQ.PK and emergency Fed support for insurer American International Group (AIG.N) in the last two weeks had increased downside risks to U.S. growth.
In addition to pumping hundreds of billions of dollars into credit markets to try to stop them from seizing up, the Fed has slashed interest rates by 325 basis points to 2 percent since September 2007 to shield the economy from the housing crisis.
These robust moves failed to turn the tide and on Friday U.S. lawmakers agreed a $700 billion bailout of the financial system to buy up tainted mortgage loans, aimed at restoring confidence and preventing more devastating runs on banks.
But stock markets slid globally on Monday, with the Dow Jones industrial average .DJI shedding 3.6 percent amid fear that seized-up credit markets will inflict recessions in the United States and in other industrial economies.
Bullard said that weaker growth may curb immediate inflation pressures, as could recent declines in commodity prices, but such moves will not banish the inflation problem being stoked currently by very easy Fed monetary policy.
"Inflation is really driven by policy in the medium run, and our policy right now is very accommodative. I think that is a risk," said Bullard, who also voiced worry that the U.S. central bank was putting its inflation credibility at risk.
"One of my main concerns is that we've been focusing so much on financial market turmoil, that is completely appropriate, but that is putting our inflation policy on the back burner," he said.
U.S. headline consumer prices rose at a year-on-year pace of 5.4 percent in July and core inflation, which excludes energy and food costs, was up by 2.5 percent over the same period.
"I think this is the most precarious situation that I've seen since I've been in the Fed, and probably since the 1970s, as far as the potential for inflation to get out of control."
"The turmoil might continue for a while, quite a while. If you say that you're going to take your eye off the inflation ball for another year, it strikes me that you could be looking at quite a bit of inflation at the other side of the crisis," Bullard said.
Instead, he argued that the experience of the U.S. savings and loans crisis of the 1980s and 1990s showed that once rates were already low, it was better to leave them alone while policies aimed at the problem banks took time to work.
"Our early 1990s experience: you go to a low rate, you stay there, and you use other tools to address the problem. I think that is a very reasonable way to think about the current situation," he said.
(Editing by Leslie Adler, Gary Hill)