Fed's Bullard: Don't cut rates back to 1 percent

BLOOMINGTON, Indiana (Reuters) - The Federal Reserve should not cut interest rates again, even though the economy may face recession, a top Fed policy-maker said on Thursday.

James Bullard, president of the Federal Reserve Bank of St. Louis, in an undated photo. REUTERS/Handout

“I think lowering interest rates right now, maybe, is not the right response,” James Bullard, president of the Federal Reserve Bank of St. Louis, told an audience at Indiana University-Bloomington after giving a speech.

Bullard’s stance contradicts investor expectations for the Fed to cut rates by a half percentage point at the U.S. central bank’s next scheduled policy meeting later this month, as implied by financial futures markets.

The Fed slashed rates by a total of 3.25 percentage points to the current 2 percent level beginning in September 2007 to offset the impact of the U.S. housing crisis on the wider economy.

Fallout from the mortgage crisis has fundamentally reshaped the U.S. financial landscape and driven Congress to consider a $700 billion bank bailout to head off feared drastic economic consequences.

Bullard, who is not a voting member of the Fed’s policy-setting committee this year, said the Fed was right to concentrate on tackling the turmoil in financial markets. But, in unusually blunt language for a policy-maker, he warned that cutting interest rates further was not the right solution.

“We’ve already lowered rates a lot. We’ve created this low interest rate environment. It is a blunt instrument ... and you’ve got this brewing inflation problem that could get out of control if we don’t keep an eye on it,” he told reporters.

Bullard also cautioned that another rate cut would put the U.S. central bank on a path toward territory that many blame for contributing to the country’s current housing woes.

“I’d be concerned about the 1 percent number. The 1 percent number was the one that was in place earlier this decade, and was at times associated with creating a lot of problems. So I think that is something to keep in mind as a policy-maker,” he said.

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On the other hand, Bullard acknowledged that recent readings from the labor market were poor and may point toward a steeper weakening in the economy than he had anticipated.

“The jobless claims, that number is at recession levels. When unemployment starts going up at the rate it is here, that is usually a recession indicator, and non-farm payrolls have been declining all year,” he said.

“The labor market part does look like recession, so I have become a little bit more pessimistic on that issue.”

Initial U.S. jobless claims jumped to 497,000 in the week ended September 27, the highest level in seven years, although a government official said that hurricanes Ike and Gustav were partly to blame for the increase.

The government’s comprehensive labor report due for release on Friday is expected to show the U.S. economy as a whole shed jobs for a ninth consecutive month in September. Economists’ median forecast is for the September non-farm payrolls report to show a loss of 100,000 jobs.

Bullard said in his speech that the economy might face a prolonged downturn, although there is also a chance of a less severe slowdown.

“There is some possibility of a relatively benign outcome, where the financial market shakeout plays itself out and real economic performance is muted but not disastrous.

“But there is also some possibility of a very adverse outcome in which the entire economy is drawn into a protracted downturn,” he said.

Bullard urged that amid all the recent dramatic financial developments, the Fed stick to its guns and not forget the lasting consequences of allowing inflation to get out of hand.

“Inflation and inflation instability put an economy’s financial sector at risk, ” he said. “Therefore, it is critical that monetary policy-makers not lose sight of the importance of maintaining price stability -- even during periods of financial turbulence,” he said.

Editing by Leslie Adler