Fed's Kohn Says Decline In Inflation Not Assured

The U.S. economy is poised for moderate growth and lower inflation, but there is no guarantee core inflation will continue to ease, Federal Reserve Vice Chairman Donald Kohn said.

"A very gradual decline in the trend rate of inflation continues to be the most likely outcome, but that path is still by no means assured," he said in remarks to the Atlanta Rotary
Club. A text of his remarks was distributed in Washington.

"And in my judgment, such a decline remains critically important to the sustained prosperity of the U.S. economy," he added.

Kohn said a period of below-trend economic growth may ease some pressures on tight labor and product markets. But some of the recent easing in inflation may reflect one-time events,
such as a drop in energy prices, he added.

"I believe it is still too early to relax our concerns about whether the run-up in price pressures in the spring and summer of last year is truly unwinding and whether it is unwinding rapidly
enough to forestall a pickup in inflation expectations," he said.

Kohn's comments were largely consistent with the Fed's most recent policy statements, reinforcing the view that officials aren't likely to lower interest rates soon. Last month, officials once again held the federal funds rate unchanged at 5.25%, as they have done since August.

Kohn indentified the "fairly tight" labor market and rising compensation as one potential threat to the downward trend in inflation if it is not matched by productivity gains.

U.S. nonfarm payrolls expanded by a stronger-than-expected 167,000 last month, while hourly wages rose 0.5%.

It is uncertain whether housing markets, which along with car industry weakness contributed to slower economic growth in 2006, have reached bottom, Kohn said.

"In my own judgment, housing starts may not be very far from their trough, but the risks around this outlook still are largely to the downside," Kohn said.

During a question-and-answer session, Kohn said the inverted shape of the U.S. Treasury yield curve was probably not a warning of economic weakness ahead and could be explained by specific influences.

"I think there are some special factors affecting that long end of the yield curve. There is a great demand for longer maturities, partly driven maybe by pension funds," Kohn said.

"Folks seem very confident that the way ahead will be a good one, that inflation will stay low, the economy will do well, and they're willing to move out the yield curve and not get the compensation they usually get," he said.

"What we're seeing is the term premium be unusually low, for reasons that are not entirely clear. So I don't think there is a strong message there for the Federal Reserve ... it is something that we pay attention to and ... try to explain and understand. My guess right now is that it is not sending a traditional signal," he said.

Separately, Kohn said, it was important for the U.S. government to put in place a plan to eliminate the budget gap in order to prepare for the retirement of the baby boom generation.

"The U.S. government has been a dissaver for the last five or six years, and the newspapers say that the president will have a plan to get us at least back to zero. I hope that's true," Kohn said in response to a question.

"To prepare for these oncoming generations -- the demographic changes -- we need to have in place a plan so that the federal government isn't using savings, but is rather adding to savings," he said, adding that such saving would help the country narrow its currently unsustainable trade deficit.