Stern Says Fed Shouldn't Wait for End of Crisis to Raise Rates

By Vivien Lou Chen

July 19 (Bloomberg) -- The Federal Reserve shouldn't wait for housing and financial markets to stabilize before it begins raising interest rates, central bank policy maker Gary Stern said.

``We're pretty well-positioned for the downside risks we might encounter from here,'' Stern, president of the Federal Reserve Bank of Minneapolis, said in an interview yesterday. ``I worry a little bit more about the prospects for inflation.''

The comments by Stern, a voter on the rate-setting Federal Open Market Committee this year, reinforced traders' forecasts for a rate increase by year-end. Stern indicated that Treasury Secretary Henry Paulson's rescue plan for Fannie Mae and Freddie Mac will help prevent a deeper housing and economic slump.

``We can't wait until we clearly observe the financial markets at normal, the economy growing robustly, and so on and so forth, before we reverse course,'' said Stern, 63, the Fed's longest-serving policy maker. ``Our actions will affect the economy in the future, not at the moment.''

The bank president compared the credit crunch to the one in the early 1990s, which restrained economic growth for almost three years. That's a more sanguine assessment than others have. The International Monetary Fund has said it's the worst financial shock since the Great Depression. Former Fed Chairman Alan Greenspan said it's the most intense in more than half a century.

Rate Outlook

Traders' estimates of a rate increase in October rose to 64 percent yesterday after Stern's remarks were published, from 58 percent earlier in the day.

Stern dissented three times in favor of raising rates in 1996. He is the only FOMC member who's served with three chairmen: Paul Volcker, Greenspan and Ben S. Bernanke. He became the Minneapolis Fed president in 1985.

His comments yesterday underscore that ``the Fed has grown more uncomfortable with the inflation situation,'' Tony Crescenzi, chief bond strategist at Miller Tabak & Co. in New York, wrote in a note to clients.

Stern spoke two days after government figures showed consumer prices surged 5 percent over the past year, the biggest jump since 1991. Excluding food and fuel, so-called core prices rose 2.4 percent, higher than the 2.1 percent average over the last five years.

`Too High'

``Headline inflation is clearly too high,'' Stern said. He added that he's concerned that will feed through to core prices and public expectations for inflation.

As long as energy and food costs level off, core inflation ought to slow over the next year, Stern said.

Crude oil has surged 73 percent in the past 12 months, and rose to a record of $147.27 a barrel on July 11. Worldwide, prices for food commodities such as wheat and rice were 43 percent higher in April than a year earlier, according to the United Nations Food and Agriculture Organization.

Stern declined to say when policy makers may shift toward raising rates.

``We're going to want to, in my opinion, reverse some of those interest-rate reductions,'' he said. ``I don't think there's any question about that. But exactly when depends on how things evolve from here.''

The FOMC halted its series of seven reductions last month, after reducing the benchmark rate to 2 percent, from 5.25 percent last September.

Traders anticipate the Fed will boost its main rate at least a quarter point from 2 percent in October, after keeping borrowing costs unchanged in August and September. There's a 79 percent probability of a move by year-end, futures prices show.

Bernanke's View

Minutes of the Fed's June 24-25 gathering, released July 15, showed that some Fed officials favored an increase in rates ``very soon.'' Bernanke this week said there are risks to both inflation and growth, abandoning the FOMC's June assessment that the threat of a ``substantial'' downturn had receded.

``This is a very challenging policy environment,'' Stern said yesterday. ``I don't think we ought to pretend that'' an end to the credit crisis ``won't take some time,'' he said.

The Fed on July 13 offered Fannie Mae and Freddie Mac access to direct loans from the central bank in case the firms needed the financing before Congress acts on Paulson's rescue plan. The Treasury chief is seeking power to make unlimited loans to and purchase equity in the companies if needed.

Stern said the Treasury proposals are ``clearly designed to bolster Fannie and Freddie, and to address'' risks the firms' troubles pose to the credit crisis and housing slump.

To contact the reporter on this story: Vivien Lou Chen in Minneapolis at vchen1@bloomberg.net