Fed's Kohn: More Trouble From Housing, Inflation

Interest rates seem to be at the right level to help the sputtering economy without sparking inflation, but policy-makers need to be ready to adjust quickly in the face of a highly uncertain outlook, Federal Reserve Vice Chairman Donald Kohn said Tuesday.

CNBC.com Donald L. Kohn

"With the information now in hand, it is my judgment that monetary policy appears to be appropriately calibrated for now to promote both rising employment and moderating inflation over the medium term," Kohn told the National Conference on Public Employee Retirement Systems.

"But a large measure of uncertainty surrounds that judgment and as the economy evolves, so will the appropriate stance of policy," he added.

Kohn sent a clear warning that the Fed is now watching inflation developments closely, and expressed concern that if longer-term inflation expectations edge higher, policy-makers will be facing "a more serious situation."

In a potentially worrying signal of inflation pressures, a government report on producer prices released Tuesday showed that so-called core inflation -- which strips out volatile food and energy costs -- had risen more than expected at the farm and factory gate in April.

At the same time, Kohn said officials will be carefully watching whether the economy can recover from the effects of a two-year housing slump and related credit crunch.

"We need also to carefully assess whether, after a period of near-term softness ..., the economy is likely to be on track for sustained economic expansion over time," he added.

Rates on Hold

The Fed has cut benchmark rates by 3.25 percentage points to 2 percent since September to buffer the sagging economy. It has also injected hundreds of billions of dollars of liquidity into financial markets to ease credit strains.

Kohn's remarks suggest the Fed is likely to hold rates steady at its next rate-setting conference on June 24-25.

Kohn sounded some warning notes about the potential for inflation to gain hold and damage the economy, even as he made clear the economy is not out of the woods.

With persistently rising prices for energy and food, inflation has been "quite elevated," he acknowledged, and added that it appeared households were building in expectations that it would continue.

While the Fed vice chair noted a moderation in core inflation, he said rising measures of inflation expectations are a concern.

"If longer-term inflation expectations were to become unmoored -- whether because of a protracted period of elevated headline inflation or because the public misinterpreted the recent substantial policy easing as suggesting that monetary policy-makers had a greater tolerance for inflation than previously thought -- then I believe that we would be facing a more serious situation," he said.

Gloomy Housing Outlook

Kohn forecast an economic rebound in the second half of the year and into 2009, but also described an economy that remains buffeted by the housing downturn and tight credit.

Home sales could fall even more in coming months given the tightness in mortgage lending, he said. Inventories of unsold homes already are high and are likely to grow as foreclosures put more homes on the market, he added.

In an environment of declining home values, tighter credit and rising energy and food prices, consumer spending -- which makes up more than two-thirds of US economic output -- has taken a hit, Kohn said.

"In reaction to these adversities, households seem to have become extremely downbeat about prospects for jobs and income," he said.

Strong exports are a bright spot, but the weaker dollar that has boosted the fortunes of  exporters raises inflation concerns, Kohn cautioned.

Meanwhile, financial markets that were badly rattled by delinquent subprime mortgages are somewhat improved, but the process of recuperation is likely to be slow and may be uneven, Kohn said.

"Investors continue to be worried about credit quality," he said. "Improvements in financial markets are vulnerable to negative news on the economy or the extent of credit losses," he added.

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