Fed's Hoenig sees rate policy in the balance

Denver, May 16: Heightened risks to both the inflation and growth outlook are holding the Federal Reserve's interest rate policy in the balance, Kansas City Fed President Thomas Hoenig said on Tuesday.

''Whether we tighten or ease will depend on how these risks play out,'' Hoenig told local business leaders at the Colorado Economic Forum.

Hoenig and Cathy Minehan, Boston Fed President, continued to focus on inflation risks on a day when core consumer inflation was reported at a lower-than-expected 2.3 percent for the year through April. Both are voting members of the Federal Open Market Committee in 2007.

Current interest rates are ''modestly firm,'' and a case could be made for either a rate hike or a rate cut, Hoenig said.

That leaves policy-makers dependent on incoming data over the next weeks and months, he said, quipping, ''I have a crystal ball. It has not served me well so far. I'm waiting.'' Last week the FOMC left overnight interest rates unchanged at 5.25 percent for a seventh consecutive meeting.

Financial markets expect the Fed to keep rates steady also at the June and August meetings, but have largely given up on the potential for another rate increase.

Balanced Comments

Instead, they expect central bankers to gradually shift their focus to slow economic growth if inflation recedes as expected, and to cut rates once late in the year.

In carefully balanced comments Hoenig said that economic growth should climb back above 2 percent over the course of 2007, and pick up further in 2008.

Among the key risks to that outlook he cited slower business investment and the weak housing market with its potential to hurt what until now has been strong consumer spending.

Strong exports, partly a result of the weak U.S. dollar, were positive for the economy, he said.

The current spell of below-potential growth should continue to bring inflation down over time, Hoenig said.

''We are growing slowly enough that we should see some slight increase in unemployment from current levels,'' he said, adding that this should help bring inflation down.

At the same time, gasoline prices which hit a record high U.S. national average price of $3.10 per gallon this week were a concern.

''That could have an increasing impact at the total CPI level and could work through to the core. That's something we need to be mindful of,'' he said.

Hoenig reiterated the central bank's commitment to keeping inflation controlled. ''Historically an economy that has an environment of stable prices functions better over time,'' he noted.

There is no trade-off between growth and inflation, Hoenig said. ''You don't give up growth by acting to make sure you don't let inflation get out of hand,'' he said.

Minehan, speaking in Sea Island, Georgia, said inflation was ''certainly challenging'' at the moment but has been trending lower.

She noted that the U.S. economy has shown resilience to high energy prices, a cooling housing market and wars in Iraq and Afghanistan and described economic growth as solid.

Turning to monetary strategy, Hoenig said that any decision by the Fed on whether to adopt formal inflation targets was still a distant prospect and more discussion within the Fed and among the academics was needed on the issue.

Targeting was just one of options that the Fed will consider to improve its communications about policy matters, he added.

A number of other Fed officials, including Chairman Ben Bernanke, steered clear of discussing the economy at the Atlanta Fed's conference on credit derivatives on Sea Island.

Instead, Bernanke urged a British-style, principles-based approach to U.S. regulation of derivatives.

''Regulators should resist the temptation to devise ad hoc rules for each new type of financial instrument,'' he said.

Reuters