Fed's Hoenig Warns Inflation Must Not Get Too High

The Federal Reserve must be ready to raise benchmark interest rates in a timely manner given the "troublesome" inflation outlook, Kansas City Fed President Thomas Hoenig said Tuesday.

"If inflation gets too high, the economy will suffer dramatically," Hoenig said, answering questions after a speech to the Economic Club of Denver.

At this point, the Fed is as much focused on higher headline inflation as core inflation, given what seem to be systematic increases in food and energy prices, he said.

Hoenig strongly hinted that he would not support more cuts to the Fed's benchmark interest rates at a time higher inflation could be getting entrenched, given prospects for growth to pick up in the second half of 2008.

First-quarter GDP growth last week was reported at an anemic 0.6 percent, matching the final quarter of 2007, and Hoenig said second-quarter GDP would also likely fall below 1.0 percent before starting to recover.

"A sharp slowdown in growth has put the economy at the brink of a recession while, at the same time, rising commodity prices have caused inflation pressures to rise considerably," Hoenig said.

But he said there were "reasons that suggest the economic slowdown will be short-lived," including but not limited to the Fed's recent "aggressive" interest rate cuts.

"The current accommodative stance should be sufficient to cushion the economy from a deeper slowdown and the risks that financial disruptions could spill over to the broader economy," Hoenig said.

Hoenig is not a voting member of the policy-setting Federal Open Market Committee in 2008.

Help from the federal government in the form of fiscal stimulus, as well as a gradual return to normalcy in financial markets, will also support growth and shift the focus back to inflation, Hoenig said.

The Fed has lowered the federal funds rate to 2 percent from 5.25 percent since mid-September, mostly recently with a quarter-point rate cut on April 30.

"As the economy recovers and credit conditions improve, however, it will be necessary for the Federal Reserve to remove the policy accommodation in a timely manner," Hoenig said.

Hoenig said rising price pressures are not temporary, as some assert, but are "more serious," pushing up inflation expectations in surveys and in financial markets.

"These increases are beginning to generate an inflation psychology to an extent that I have not seen since the 1970s and early 1980s," he said.

Answering questions from the audience, Hoenig even referred to hyperinflation in Germany in the 1920s, and said that an annual rate in the 6 percent to 7 percent range "has an enormous effect on investment decisions."

In the year through March, overall consumer price index inflation rose by 4 percent, and the core CPI, which excludes food and energy, rose by 2.4 percent.

If an inflationary psychology becomes embedded, it will "require significant monetary policy tightening to reduce it," he said.

MORAL HAZARD RISK

Hoenig spoke at length about fallout in financial markets from the subprime mortgage crisis and its cascading series of events in global money markets.

"The recent sale of Bear Stearns seems to indicate that in a crisis situation, public authorities will not be in a position to let market discipline play out," he said.

The Fed helped finance the takeover of troubled investment bank Bear Stearns by JPMorgan Chase earlier this year. When pressed, Hoenig said that he supported the Fed's move.

"Moral hazard problems may be inherent in some of the recent and more expansive proposals to support housing markets and in the actions the Federal Reserve has had to take to provide liquidity."

The crisis in the U.S. subprime mortgage market that erupted in 2007 exposed broader flaws in the financial system, not least of which was "greed-induced myopia," Hoenig said.

"Rising subprime delinquencies provided the spark that started the financial conflagration, but there was a lot of dry tinder to spread the fire and an absence of firewalls and a sprinkler system to contain the blaze."

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