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UPDATE 2-Kohn warns Congress on meddling in Fed's affairs

(Adds more Kohn remarks, background)

WASHINGTON, July 9 (Reuters) - The U.S. Federal Reserve on Thursday launched a robust defense of its independence and warned that efforts in Congress to put monetary policy under political sway would hurt the economy.

Fed Vice Chairman Donald Kohn said opening up some of the U.S. central bank’s most sensitive decisions to political scrutiny could result in higher long-term interest rates and hurt the United States’ credit rating. Kohn was speaking before a Congressional panel where he was seeking to beat back a proposal that would open policy decisions by the U.S. central bank to audits by a federal watchdog agency.

“Any substantial erosion of the Federal Reserve’s monetary independence likely would lead to higher long-term interest rates as investors begin to fear future inflation,” he said in testimony prepared for delivery to a House of Representatives Financial Services subcommittee.

Kohn’s testimony comes as Congress debates President Barack Obama’s plan for regulatory reform, which envisions the Fed taking on an expanded role monitoring risks across the entire financial system to help ward off future financial crises.

The proposal has increased calls for greater accountability at the central bank, which was already facing heavy scrutiny from lawmakers angered by its role in bailing out Wall Street.

Public anger over last year’s financial crisis and Fed-backed bailouts of investment bank Bear Stearns and insurer American International Group has created a popular backlash that could gain momentum in Congress.

A bill put forward by Representative Ron Paul, a Texas Republican, would expose the Fed’s decisions on monetary policy and emergency lending to audits by the Government Accountability Office. It has won support from a majority in the House of Representatives.

The GAO is currently prohibited from auditing these areas. Kohn said removing this exclusion would be highly detrimental and could lead investors to worry politics -- not economics -- would guide the Fed’s decisions.

“The Federal Reserve strongly believes that removing the statutory limits on GAO audits of monetary policy matters would be contrary to the public interest by tending to undermine the independence and efficacy of monetary policy,” he said.

He also said it could “cast a chill” on monetary policy deliberations by making officials nervous ideas they throw around behind closed doors could become public.

Paul’s bill has 250 co-sponsors, including 78 Democrats. But it has not been promoted by the Democratic majority leadership in the House, where it has yet to face even a committee-level vote.

If it were to emerge from the House, to become law it would also need to clear the Senate, where support may be more scarce.

Kohn warned that congressional meddling in the Fed’s affairs could exact a high cost.

“The bond rating agencies view operational independence of a country’s central bank as an important factor in determining sovereign credit ratings, suggesting that a threat to the Federal Reserve’s independence could lower the Treasury’s debt rating and thus raise its cost of borrowing,” he said.

He made plain the Fed saw Paul’s bill as a direct challenge to its independence that could raise the risk investors might begin to expect the U.S. central bank to start printing money to help the government finance a growing budget gap.

“History provides numerous examples of non-independent central banks being forced to finance large government budget deficits. Such episodes invariably lead to high inflation,” he said. “Given the current outlook for large federal budget deficits in the United States, this consideration is especially important.”

Some investors are already worried that a new Fed program to buy longer-term U.S. Treasury securities has opened the door to a “monetization” of the debt.

The Fed rejects this view, but is clearly worried this impression could take firmer root among investors if Congress extends its influence over monetary policy. (Additional reporting by Emily Kaiser; Editing by Chizu Nomiyama)