UPDATE 1-Fed's Plosser sees risk in bank's pledge on low rates

* Plosser warns on destabilizing inflation expectations

* Plosser says worried by Fed focus on mortgage securities

(Adds comments on purchases of mortgage-backed securities,byline)

By Jonathan Spicer

AVONDALE, Penn., Oct 11 (Reuters) - The Federal Reserve'sintention to keep interest rates ultra low for nearly three moreyears is suggesting to some that the Fed is willing to cut thejobless rate at the expense of higher inflation, putting thecentral bank's credibility at risk, a top Fed official said onThursday

Charles Plosser, president of the Philadelphia Fed and oneof the most hawkish of the Fed's 19 policymakers, weighed in onthe simmering debate over just how high U.S. monetarypolicymakers would allow inflation to rise in order to boostweak economic growth and lower unemployment.

The debate has amplified - both among Fed policymakers andoutside economists - since the policy-making Federal Open MarketCommittee (FOMC) last month launched a third and potentiallymassive round of asset purchases and said it expected to keepshort-term borrowing costs near zero through mid-2015.

Plosser, who opposed the policy action, said in a speechthat keeping the federal funds rate so low for so long "wouldrisk destabilizing inflation expectations and lead to anunwanted" rise in inflation.

"In fact, some are interpreting the FOMC's statement that wewill keep accommodation in place for a considerable time afterthe recovery strengthens as an indication that the Fed isfocused on trying to lower the unemployment rate and is willingto tolerate higher inflation to do so," he told a luncheonhosted by the Southern Chester County Chamber of Commerce.

"This is another risk to the hard-won credibility theinstitution has built up over many years, which, if lost, willundermine economic stability," he said in his speech at a golfclub in this wealthy region of southeastern Pennsylvania.

Though U.S. unemployment fell sharply to 7.8 percent lastmonth, from 8.1 percent in August, analysts doubt that rate ofimprovement can be sustained.

Inflation, meanwhile, has remained relatively stable nearthe Fed's 2 percent target for almost three years. It is nowtracking slightly below that target.


Since the Fed's latest easing move, three of Plosser'scolleagues - Chicago Fed President Charles Evans, NarayanaKocherlakota of Minneapolis and John Williams of San Francisco -have each specified how high above 2 percent they would allowinflation to rise before tightening policy.

Economic theory suggests that higher inflation expectationshave the same impact as easier monetary policy: loweringinflation-adjusted "real" interest rates, and encouragingborrowing, investment and hiring.

"We know that monetary policy can control inflation, but itsability to manage the unemployment rate is far more dubious,"said Plosser, who does not have a vote this year on Fed policy.

"Chasing an elusive goal for unemployment could well risklosing control over inflation," he added. "That was the lessonof the Great Inflation during the 1970s."

U.S. economic growth cooled in the second quarter to a 1.3percent annual rate, and forecasters do not think the economy isexpanding much faster now.

In part responding to this tepid growth, the Fed on Sept. 13said it would keep buying mortgage-backed securities or otherassets until the outlook for the labor market improvessubstantially, within a context of price stability.

Plosser said he, for one, interprets that to mean "so longas the inflation outlook remains near" the 2 percent goal.

Evans, the most dovish of the Fed's policymakers, has saidhe would be comfortable letting inflation run as high as 3percent as long as the labor market was improving.

Plosser also voiced concerns over the Fed's targeting ofsecurities linked to the housing sector for the central bank'sthird round of quantitative easing, as opposed to governmentbonds, something that he said amounted to an allocation ofcredit toward one sector of the economy.

That's a job better left to fiscal policymakers, Plossersaid, adding that it "endangers our independence and theeffectiveness of monetary policy."

(Reporting by Jonathan Spicer; Editing by Leslie Adler)

((jonathan.spicer@thomsonreuters.com)(+1 646 223 6253)(ReutersMessaging: jonathan.spicer.reuters.com@reuters.net))