Fed's Lacker Says Risks to U.S. Economy `Diminished'

Richmond Federal Reserve Bank President Jeffrey Lacker said downside risks to growth have ``diminished'' and reversing previous interest rate cuts makes ``eminent sense'' as the economy recovers.

While the danger of a more rapid slowing in growth ``has not entirely disappeared, my sense is that such downside risks have diminished appreciably,'' Lacker said today in a speech in Spartanburg, South Carolina. ``And just as easing policy aggressively in response to emerging downside risks made sense, withdrawing some of that stimulus as those risks diminish makes eminent sense as well.''

Comments by Fed officials this month have led traders to increase bets the central bank will start lifting the main interest rate later this year to keep rising food and energy prices from fueling an increase in other prices, as well as demands for higher wages.

Lacker said the economy is growing at a ``tepid pace overall'' hindered by weak housing markets. ``Even if housing market activity does manage to bottom out later this year, it is likely that any recovery would be exceedingly slow,'' Lacker said.

The Federal Open Market Committee cut the benchmark lending rate 2.25 percentage points from January to April, the fastest easing in two decades, to cushion the economy from the worst housing recession in a quarter century.

The consumer price index rose 0.6 percent in May, the most since November. Prices climbed 4.2 percent in the 12 months to May, and 2.3 percent minus food and energy, the Labor Department reported last week.

`Unacceptably High'

``The latest figures confirm that inflation is unacceptably high,'' Lacker said. ``We need to be attuned to the risk that we emerge from the slowdown with inflation following a higher trend than when we went in.''

Fed officials are concerned the rise in prices could become embedded in public expectations and thereby accelerate inflation. The public's outlook for annual inflation over five years stood at 3.4 percent in June, up from 2.9 percent the same month a year earlier, according to the Reuters/University of Michigan Survey.

Maintaining inflation credibility ``depends on continuing to conduct policy in a way that is consistent with the stability of inflation expectations, and acting forcefully should those expectations erode.''

Fed Chairman Ben S. Bernanke said the FOMC ``will strongly resist an erosion in longer-term inflation expectations'' in a June 9 speech.

Quarter-Point Increase

Fed officials next meet June 24-25, when they plan to vote on interest rates and discuss their forecasts for growth, employment and inflation. Federal funds futures markets now show a 20 percent probability of a quarter-point increase this month in the policy rate, up from zero a month ago. The federal funds rate is now at 2 percent.

The economy grew 0.9 percent in the first quarter, the Commerce Department reported last month, the second three-month period of annualized growth rates below one percent. Private- sector employers have cut payrolls for six consecutive months, helping push the U.S. unemployment rate up to 5.5 percent in May, the highest in almost four years.

Lacker Dissented

The Richmond Fed has a tradition of favoring low rates of inflation and a constrained role for the central bank in monetary policy and discount window lending. Lacker has said he wants the Fed to announce a numeric goal for inflation rather than leave that goal ambiguous.

Lacker dissented in favor of higher interest rates in his last four meetings as an FOMC voting member in 2006. He returns as a voting member next year.

The Richmond Fed president recently warned against providing backstop financing to non-bank financial institutions facing fundamental credit problems. The Fed Board in Washington opened a separate discount window for primary government bond dealers on March 16 to increase liquidity.

``Establishing a new set of boundaries for central-bank lending is a high priority,'' Lacker, 52, said June 5 in an interview. ``You would expect that'' the limits ``aren't going to be credible unless we let somebody fail in a costly way that is beyond that scope,'' he said.