Fed's Plosser: Market woes warrant low rates

WASHINGTON (Reuters) - U.S. financial turmoil is serious enough for the Federal Reserve to lower interest rates, but the central bank should be ready to raise rates when conditions stabilize, Philadelphia Federal Reserve Bank President Charles Plosser said on Monday.

Traders work on the floor of the New York Stock Exchange February 29, 2008. REUTERS/Brendan McDermid

“The severity of events affecting the smooth functioning of financial markets suggests that rates, perhaps, should be somewhat lower than simple rules might suggest,” Plosser said in remarks to the National Association for Business Economics.

“Departures from the more systematic elements of making policy decisions must be relatively transitory and reversed in due course if we are to keep expectations of future inflation well-anchored,” he said.

The Fed has slashed interest rates by 2.25 percentage points since mid-September to shield the economy from a collapse in the housing market, which has chilled growth and sparked a global tightening in credit conditions.

This muscular response and doubts over the U.S. economic outlook have contributed to a sharp decline in the dollar, which touched a fresh low against a basket of major currencies on Monday.

Plosser said it was very difficult to forecast exchange rates with any accuracy, but acknowledged the U.S. current account deficit might be weighing on the currency.

“A lot of people have been predicting for a long time that given the size of our current account deficit, that there was going to be continued pressure on exchange rates to adjust to help eliminate that,” Plosser said.

“Indeed, that is partly what has happened. That process will no doubt continue,” he added.

Plosser said central banks are usually best served by following clear guidelines for setting interest rates in response to changes in inflation, growth and workforce productivity.

Such rules would call for interest rates above the Fed’s current 3 percent target for the benchmark fed funds rate, Plosser said. But the unusual nature of current market turmoil justifies setting rules aside for the time being.

“We are now, perhaps, in a period of extraordinary circumstances and have deviated from the benchmarks suggested by simple rules,” he said. “But such deviations should be temporary and limited and promptly reversed when conditions return to normal.”

In particular, Plosser emphasized the importance of keeping inflation expectations under control, conceding that these had recently deteriorated.

“There are some signs that they (inflation expectations) are creeping up a bit,” Plosser told reporters after the speech. “I am not panicked ... but they certainly bear our monitoring.”

“We can’t wait too long for inflation expectations to materialize. ... We have to be very cautious and very alert to monitoring these things,” he said.

“The issue of inflation is both worrisome and highly uncertain,” he said. “It has risen and is not at comfortable levels,” Plosser added.

He also stressed that policy works with a lag and central bankers need to be forward looking in their decisions.

“No matter what monetary policy does, its primary effects on employment and output, are going to be at least nine months, 12 months, maybe even two years out. And its effects on inflation may be at least that long to,” he said.

Reporting by Mark Felsenthal and Alister Bull; Editing by Neil Stempleman