Fed's Hoenig says fiscal strains pressuring Fed

Growing mountains of U.S. government debt will increase pressure on Federal Reserve to hold interest rates low, making it harder to avoid inflation, a senior Fed official said on Tuesday.

The current outlook for fiscal policy poses a threat to the Federal Reserve's ability to achieve its dual objectives of price stability and maximum sustainable long-term growth, and therefore is a threat to its independence as well, Kansas City Federal Reserve Bank President Thomas Hoenig told the Peterson-Pew Commission on Budget Reform.

Hoenig, a voter this year on the Fed's interest-rate setting committee, also urged the U.S. central bank sell some of the assets it has acquired to help counter the worst economic downturn since the 1930s.

Holding them for an extended period will invite pressure from politicians to use Fed powers to aid other ailing sectors of the economy, he said.

GOOD NEWS ON INFLATION

Hoenig's remarks were in keeping with his views as one of the more vigilant anti-inflation hawks on the Fed. They contrasted with those of another Fed official who said on Tuesday that inflation was well in hand and would only be a problem if both monetary and fiscal policymakers stumble badly.

The news is mostly good on the inflation front, although the need for careful policy choices is even more critical than usual, Minneapolis Federal Reserve Bank President Narayana Kocherlakota told a group of bankers in St. Paul, Minnesota.

In remarks that helped lift prices for U.S. government debt, Kocherlakota said the U.S. economy would likely grow at a pace close to 3 percent over the next two years, slower than many private-sector economics predict.

He said the jobless rate. which stood at 9.7 percent in January, was unlikely to drop below 9 percent this year and below 8 percent in 2011.

Hoenig focused on the potential for the budget deficit, which is projected to rise to $1.56 trillion, or 10.6 percent of the economy this year, to tip the United States into another crisis.

Risks from the deficit were underscored earlier this month when a debt-rating agency said the gap could put the country's top-level debt rating at risk.

Hoenig said fiscal policymakers would need to embark upon the difficult path of cutting spending and increasing revenues.

If not addressed, the deficit problem could sap the Fed's ability to maintain the value of the dollar, he warned.

Although the U.S. government is currently privileged to borrow at favorable rates, the fiscal outlook would inevitably undermine this privilege and its risk premium on debt would increase, he said. Slowly, but inevitably, if the fiscal debt goes unaddressed, the currency weakens, as does access to global financial markets.

HIGHER INFLATION TARGETS RISKY

Hoenig rejected a suggestion made recently by economists at the International Monetary Fund that central banks should permit higher levels of inflation than in the past to be better equipped to combat serious downturns.

An IMF staff paper released on Friday suggested policymakers might consider raising their inflation target to 4 percent from 2 percent to allow monetary policy to be more effective in future deflationary crises.

My concern is that it rationalizes solutions to short-term problems that too often take an economy down the wrong path, Hoenig said.

The Kansas City Fed president said high debt further risks attracting political meddling in the Fed's conduct of monetary policy. Historically, political influence over central banks has led to major inflation, he said.

The Fed pumped more than $1 trillion into the U.S. economy to continue to help the economy after it had cut interest rates to near zero. Many -- including Hoenig -- worry the massive amount of cash in the financial system will fuel runaway inflation when the economic recovery gains strength.

We need to remove those assets as quickly but as carefully as we can, he said.

His remarks reflect debate at the Fed about what to do with the $1.4 trillion in mortgage-related securities it is on track to own. Fed Chairman Ben Bernanke said last week the Fed might eventually sell some, but only once the recovery is firmly under way.

The Fed has said the weak economy continues to need the help of rock-bottom borrowing costs and a financial system flush with money, and it has the tools to remove those supports when economic growth gains traction.

Hoenig dissented in January against the Fed's decision to continue to promise that it would hold interest rates exceptionally low for an extended period. He said he believes the economy has recovered sufficiently for the Fed to remove that pledge.

(Additional reporting by Ann Saphir in St. Paul, Minnesota; Editing by Neil Stempleman)