Increasingly hawkish Fed ponders raising rates

ATLANTA (Reuters) - Two top Federal Reserve officials said on Thursday it may soon be time to begin raising interest rates as the U.S. economic recovery gathers momentum, despite persistent unemployment.

Thomas Hoenig, president of the Kansas City Fed, argued the U.S. central bank should raise benchmark borrowing costs, currently near zero, to 1 percent by the end of summer.

The head of the Atlanta Fed, Dennis Lockhart, said policy makers should soon begin thinking about tightening monetary policy, though he stopped short of calling for an imminent move.

Their comments suggest that firmer growth in the United States is making some Fed policy makers nervous about keeping rates too low for too long, even as uncertainty mounts regarding European debt markets.

“Based on the current outlook consensus, it seems reasonable that the economy would be well-positioned to accept this modest increase in the funds rate,” Hoenig said in remarks to a business lunch in Bartlesville, Oklahoma, expounding on his view on raising the benchmark federal funds lending rate to 1 percent.

Lockhart also warned of the threat from inflation.

“As the economy continues to improve and financial markets find firmer ground, extraordinarily low policy rates will not be needed to promote recovery and will become inconsistent with maintaining price stability,” Lockhart told local business leaders at the Atlanta Technical College.

In response to the most severe financial crisis in generations, the Fed slashed interest rates effectively to zero and undertook a host of emergency measures, such as buying up over $1.7 trillion in Treasury and mortgage bonds.

U.S. gross domestic product has been climbing since last summer, expanding at a 3.0 percent annualized rate in the first quarter.

But even as the economy has expanded, the labor market has lagged.

Fed Chairman Ben Bernanke on Thursday bemoaned the slow pace of employment growth.

“One particularly difficult issue is the continued high rate of unemployment,” Bernanke said at a meeting on small business in Detroit.

Bernanke, whose remarks came a day ahead of the release of the government’s key monthly payrolls report, did not go into much detail regarding the current outlook for the U.S. economy or monetary policy.

U.S. unemployment stood at 9.9 percent in April, and is expected to remain elevated for the foreseeable future. Job growth is starting to pick up, however, with employers having added new jobs to their payrolls in five of the last six months.

HOENIG SAYS RATES COULD BE RAISED FURTHER

While Hoenig is considered one of the more hawkish members of the Federal Open Market Committee, the body known as the FOMC that sets official interest rates, Lockhart had until recently been quite dovish, tending to focus more on the economy’s weak spots than its strength.

Even Hoenig, who is a voter on the FOMC this year and has dissented three times in favor of softening the Fed’s pledge to keep rates low for an “extended period,” seemed to be stepping up his calls for tighter policy.

Hoenig suggested the Fed first boost rates to 1 percent, pause to assess the effects of this tightening, and then proceed to raise them further up to above 3 percent “reasonably quickly.”

In addition, he called for the Fed to sell some of the mortgage assets acquired during the crisis at least by the time it pushes the benchmark federal funds rate up to 1 percent, even sooner.

Lockhart, who does not have a policy vote in 2010, offered a view that is more in line with the central bank’s influential Washington board. He said the Fed should begin the tightening process by draining reserves from the banking system and raising its interest rate target. Asset sales, he said, should be left for later.

A key caveat to the Fed’s increasingly hawkish tone was an ongoing crisis of confidence in key European economies plagued by high debt levels. The crisis has taken a toll on asset prices worldwide, and has pushed U.S. stocks down nearly 10 percent in just over a month.

Both Lockhart and Hoenig agreed this posed some risk to the U.S. outlook. Lockhart said Europe’s troubles could prompt the Fed to hold off a little longer on tightening.