Economic growth will be “sluggish” for “several quarters” before sustained expansion returns, but risks to the downside could force the Fed to cut rates again, according to Federal Reserve Bank of Philadelphia president Charles I. Plosser.

“A substantially weaker outlook than expected, particularly if that weakness is projected to be more prolonged than anticipated, may require further adjustments to policy,” Plosser told the Main Line Chamber of Commerce in Pennsylvania yesterday, according to prepared text of the speech released by the Fed.

In addition to the risk of weak growth, “we also face risks of higher inflation,” Plosser said. “Consequently, we must remain vigilant on the inflation front and be prepared to act as necessary to avoid the risk of undermining public confidence in the central bank’s commitment to price stability.”

The subprime mortgage crisis left markets “struggling to reassess the risks of such assets in order to determine an appropriate price,” he said. “The Federal Reserve cannot resolve this price discovery problem. The markets will have to sort it out. Providing liquidity to the market does not solve the fundamental problems of re-pricing risky assets and assessing counterparty risks.

“A necessary step in restoring both confidence and credibility in the financial system is for financial institutions to promptly recognize and disclose the extent of their losses,” Plosser added. “Of course, this is easier said than done, since some of the assets that need revaluing are only thinly traded and prices are hard to come by. Nevertheless, write-downs play a necessary and important role in restoring the health of financial markets.”

He noted that the Fed has other ways to help the market without changing rates. “Going forward, we must be careful to distinguish when financial conditions call for Fed actions to help markets function effectively, such as we are now seeing with the Term Auction Facility, as opposed to situations when a change in the overall stance of monetary policy is called for,” he said.

“I am concerned that developments on the inflation front will make the Fed’s policy decisions more difficult in 2008,” Plosser said. “Recent data suggest that inflation is becoming more broad-based. Recent increases do not appear to be solely related to the rise in energy prices. Consequently, I see more worrisome signs of underlying price pressures. Although I am expecting slow economic growth for several quarters, we should not rely on slow growth to reduce inflation. Indeed, the 1970s should be a sufficient reminder that slow growth and falling inflation do not necessarily go hand in hand. Moreover, the 1990s should remind us that we can have sustained economic growth without generating inflation.

“Although inflationary expectations have crept up only slightly since early September based on inflation-indexed Treasury securities, my sense is that these inflation expectations are more fragile now than they were six months ago,” Plosser said. “If inflation expectations continue to rise, it will be difficult and costly to the economy to deliver on our goal of price stability and puts at risk the Fed’s credibility for maintaining low and stable inflation.”


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