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* With low rates, signs of financial instability inevitable
* Keep economy at appropriate temperature, Fed official says
By Jonathan Spicer and Leah Schnurr
NEW YORK, April 18 (Reuters) - The Federal Reserve's ultra accommodative policies will inevitably result in financial market instability for years but such risks are necessary to boost employment and inflation, a top U.S. central bank official said on Thursday.
Likening the Fed to a Minnesotan heading out into the winter cold, Minneapolis Fed President Narayana Kocherlakota said low real interest rates are as necessary as wearing a warm parka, and will probably be needed for many more years.
Kocherlakota is probably the most dovish of the 19 policymakers at the Fed, which has kept borrowing costs low for more than four years and is snapping up $85 billion in bonds each month to stimulate the U.S. economic recovery.
Bolstering his argument for yet more easing, the Minneapolis policymaker said the weak economic outlook suggests borrowing costs should be lower for even longer than the Fed now plans despite the inflated asset prices, volatile returns, and higher corporate merger activity that will result.
"For many years to come," he said, the Fed's policy-setting committee "will only be able to achieve its congressionally mandated objectives by following policies that result in signs of financial market instability," Kocherlakota told a Hyman P. Minsky conference.
Financial regulation is the best defense against such instability, he said.
But if the Fed considers raising rates to stabilize things, it has to weigh "the certainty of a costly" departure from achieving maximum employment and price stability against the benefit of reducing "the probability of an even larger" departure those objectives, Kocherlakota warned.
Central bank policymakers would also have to consider the effect a sooner-than-desired rate-rise would have on the Fed's overall credibility, he later told reporters. "That's going be part of the question you have to ask yourself," he said.
Frustrated with the slow and erratic recovery, the central bank has said it will keep short-term rates low until the unemployment rate falls to at least 6.5 percent, from 7.6 percent last month, as long as inflation, now below the Fed's 2-percent target, remains contained.
Meanwhile the Fed's bond-buying is meant to depress longer term rates and encourage investing, hiring and economic growth.
Kocherlakota is alone among policymakers in wanting the central bank to aim to keep rates low until unemployment falls as low as 5.5 percent, a level to which Americans are more accustomed.
Kocherlakota, whose hometown is expecting yet another spring snowfall, said the policy-setting Federal Open Market Committee (FOMC) is responding to forces beyond its control when it decides how long to keep rates low, given it is falling short of both its employment and inflation goals.
"When I decide what coat to wear, my goal is to keep myself at a temperature that I view as appropriate, given prevailing conditions that I cannot influence," he said.
"Similarly, when the FOMC decides on a level of the real interest rate, its goal is to keep the macro economy at an appropriate temperature, given prevailing conditions that it cannot influence," he added. "But the truth is that the FOMC's choice of winter garb is actually insufficient to keep the U.S. economy appropriately warm."
Talking to reporters, he did not go so far as to call for more asset purchases. But he said it was very important that the Fed protects its 2-percent inflation target "both from above, which gets so much attention, but from below as well."
On Wednesday, St. Louis Fed President James Bullard surprised some economists when he said the central bank should ramp up its quantitative easing program if inflation continues to fall. According to the Fed's preferred measure, inflation is at about 1.3 percent.
In his speech, Kocherlakota added he expects credit markets will remain limited over the next five to 10 years, causing headaches for investors seeking safe-haven assets.