The Federal Reserve should tighten policy sooner rather than later to contain longer-term inflation pressures and avoid sowing the seeds of the next crisis, a top Federal Reserve policy-maker said on Thursday.

The U.S. and world economies appear to be in the early stages of recovery, Federal Reserve Bank of Kansas City President Thomas Hoenig told a conference at the Central Exchange in Kansas City. In the U.S., labor market conditions have begun to stabilize and the housing market shows signs of recovery, he said.

Uncertainty remains, however, with the unemployment rate unacceptably high, he said, and short-term inflation risks are likely small.

While there is considerable uncertainty about the outlook, the balance of evidence suggests that the recovery is gaining momentum. In these circumstances, I believe the process of returning policy to a more balanced weighing of short-run and longer-run economic and financial goals should occur sooner rather than later, Hoenig said.

We cannot afford to be short-sighted, he said.

The Fed cut its benchmark federal funds rate to near zero in December 2008 and created a host of emergency lending facilities and bought mortgage-related to fight the worst recession in more than 70 years. It has pledged low rates for an extended period.

If we leave it (the fed funds rate) there too long, then we will invite a new set of instabilities or inflation, Hoenig said in response to an audience question.

Hoenig, who is seen as one of the more hawkish, or anti-inflationary, policymakers at the U.S. central bank, and is a voting member of the Fed's rate-setting committee this year. He has warned about the risk of keeping interest rates too low for too long before, including in a speech last October.

Maintaining excessively low interest rates for a lengthy period runs the risk of creating new kinds of asset misallocations, more volatile and higher long-run inflation, and more unemployment -- not today, perhaps, but in the medium

and longer run, Hoenig said.

Most analysts don't expect the Fed to raise interest rates until the second half of 2010.

Hoenig also argued that keeping short-term interest rates near zero could actually hurt the recovery process in financial markets.

With a low federal funds rate and a small spread between the discount rate and the rate paid on excess reserves, banks are more inclined to transact with the Fed instead of with each other. That prevents the interbank markets from working effectively, Hoenig said. Low rates also distort longer-term saving and investment decisions, he added.

Hoenig said he is more optimistic than most on the outlook for the U.S. economy, and expects 3 percent gross domestic product growth at least through 2010.

Hoenig nodded to differences of opinions amongst policy-makers about when the Fed should start withdrawing its extraordinary support for the economy and financial markets.

Normalizing the Federal Reserve's balance sheet -- which more than doubled to $2 trillion during the crisis response-- will be a far more contentious undertaking, and there are differing views regarding when this process should begin, how fast it should proceed, and what form it should take.

One view, he said, is to wait until there is more certainty that the economy has completely recovered, given high unemployment and low inflationary pressures.

But Hoenig said that while this view may seem appealing, it runs the risk of causing the Fed to wait too long.

While the economic and financial recovery is gaining traction, risks and uncertainty remain major deterrents to removing the stimulus. Unfortunately, mixed data are a part of all recoveries, Hoenig said.

While I agree that unemployment is unacceptably high and short-term inflation risks are likely small, we must also recognize what monetary policy can and cannot do, he said. Monetary policy is not an appropriate tool for addressing structural unemployment problems, Hoenig argued.

The Fed's tough task as the economic recovery gains traction will be to curtail its emergency credit and financial market support programs and raise the federal funds rate target from zero back to a more normal level, probably between 3.5 and 4.5 percent, and restore its balance sheet to pre-crisis size and configuration, Hoenig said.

(Reporting by Kristina Cooke; Editing by Andrew Hay)

Inflation