October 2, 2009 / 1:43 PM / 9 years ago

UPDATE 2-Fed's Rosengren cautions against hasty retreat

(Adds non-farm payrolls report, details from Q&A)

By Pedro Nicolaci da Costa

BOSTON, Oct 2 (Reuters) - The U.S. economy remains vulnerable despite signs of stabilization, and the Federal Reserve should resist the temptation to tighten monetary policy too soon, Boston Fed President Eric Rosengren said on Friday.

Improved stock prices for financial firms reflect an increased faith in their ability to withstand lingering credit issues, Rosengren said. Yet he added the economy’s actual strength might fall short of what markets were expecting.

“The economic recovery remains fragile and quite capable of falling short of the more positive expectations and degrees of confidence now reflected in financial markets,” Rosengren told the Greater Boston Chamber Financial Services Forum.

The call for restraint in removing stimulus was at odds with recent statements from some other top Fed officials. Some have alluded to the possibility that an eventual retreat from the central bank’s rock-bottom interest rate strategy, while not imminent, might be swifter than many investors expect.

Fed Board Governor Kevin Warsh rattled the bond market last week when he first offered this line of argument in a newspaper editorial.

But Rosengren appeared to be of a very different view. He focused on Japan’s experience to make the case that, despite the Fed’s unprecedented monetary interventionism, there will be no immediate risk of inflation as long as there is plenty of slack in the economy.

“I personally expect our primary short-run concern to be disinflation rather than inflation,” Rosengren said.

In this context, Rosengren said both monetary and fiscal policy should continue to support the weakened economy until private sector activity resumes, and that that was the only way policy-makers will make headway against a stubborn jobless rate.

U.S. employers slashed 263,000 jobs in September, according to Labor Department data released on Friday, pushing the unemployment rate to a 26-year high of 9.8 percent.

Rosengren said that while U.S. gross domestic product should be positive in the third and fourth quarters — a reiteration of the Fed’s view — he did not believe such growth would be sufficient to put a dent in the unemployment rate.

FORK IN THE ROAD

Rosengren expressed surprise at how divergent forecasters had become on inflation in an environment of uncertainty. He attributed the gap to two different philosophies — one that emphasizes the amount of spare capacity in a recessionary economy, and the other more concerned with the overall amount of central bank reserves in the system.

Clearly in the former camp, Rosengren made the case that central bank credit means nothing if banks continue to hold on to them without making loans, which he argued they are currently doing.

“Dormant, unlent bank reserves have little if any effect on spending — and consequently, in an environment of significant excess capacity, will do little to spur an increase in inflation,” he maintained.

He said commercial real estate, whose trajectory has recently gone the way of housing, could pose a real problem for banks currently trying to rebuild their balance sheets from the ravaging effects of the global financial crisis.

In response to audience questions, Rosengren said: “I am worried about capital losses coming from commercial real estate possibly creating some issues for financial institutions around the country.” (Editing by Chizu Nomiyama)

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