By Steven K. Beckner

SANTA FE, New Mexico (MNI) – Although an accommodative monetary
policy is still warranted to promote economic recovery, Kansas City
Federal Reserve Bank President Thomas Hoenig proposed Wednesday that the
Fed move “soon” to raise the federal funds rate toward a still
accommodative 1%.

Hoenig, a voting member of the Fed’s policymaking Federal Open
Market Committee, warned that by holding the funds rate near zero and
advertizing its expectation that it will stay there “for an extended
period,” the FOMC is risking financial imbalances and other problems.

It is a caveat he has issued before in dissenting against the
“extended period” language at the last two FOMC meetings.

Hoenig said inflation is likely to remain low for the next year or
two, but said that very low interest rates and the seeming promise of
their continuation are already fuelling a flood of money into junk
bonds, farmland and other assets.

He said investors are taking positions in anticipation of continued
zero rates.

So Hoenig proposed a different approach to monetary policy that
would move the Fed away from zero without being unduly restrictive of
economic growth.

“An alternative policy option is to be more proactive, but
cautious,” he said. “This would require initiating a reversal of policy
earlier in the recovery while the data are still mixed but generally
positive.”

“Small reversals in rates would leave policy highly accommodative
and supportive of our economy’s recovery but would put more weight on
mitigating the risk of longer-run financial imbalances,” he said. “It
would end the borrowing subsidy more quickly and would moderate credit
conditions in a more timely fashion.”

“It would reduce the likelihood that inflationary pressures might
build, or that financial imbalances might emerge,” Hoenig continued.
“And over time it would contribute to greater macroeconomic stability.”

“Under this policy course, the FOMC would initiate sometime soon
the process of raising the federal funds rate target toward 1%,” he
added.

“I would view a move to 1% as simply a continuation of our strategy
to remove measures that were originally implemented in response to the
intensification of the financial crisis that erupted in the fall of
2008,” he went on. “In addition, a federal funds rate of 1% would still
represent highly accommodative policy.”

“From this point, further adjustments of the federal funds rate
would depend on how economic and financial conditions develop,” he
added.

Hoenig prefaced those comments by casting a wary eye on recent
development in asset markets.

Noting that a record $31.5 billion of junk bonds came to market
last month and that investments in bond mutual funds hit a record high
last year, he observed, “Thanks to the combination of near-zero short
term interest rates and the Federal Reserve’s large-scale purchases of
mortgage-backed securities, investors are flush with cash. And, as is
sometimes the case, cash earning so little is an enticement to take on
additional risk in hopes of higher returns.”

Hoenig said “the bond market is not the only place where we are
seeing the impact of cash-rich investors.” He added that contacts in his
Tenth Federal Reserve District have been telling the Kansas City Fed
that “operators and investors in the Midwest are buying farmland and
bidding up the price.” And he recalled that the same phenomenon occurred
in the run-up to the banking crisis of the 1980s.

“Events such as these, along with new economic research now coming
to light, are beginning to document a story about long-run risks that
are created when money and credit are easy for too long, when interest
rates are near zero, and when financial imbalances risk macroeconomic
and financial instability,” he said.

Although the Fed averted a worse financial crisis by taking
extraordinary actions to inject liquidity into markets and lower
interest rates, Hoenig suggested these policies need to be reconsidered
now “as the economy turns the corner and we move beyond the crisis.”

“The economy appears to be on the road to recovery, and we find
ourselves having to face important questions of how the Federal Reserve
will unwind the policy response to the crisis,” he said. “In particular,
what are the hazards of holding the federal funds rate target close to
zero?”

“The risks of raising rates too soon are clear and compelling,” he
said. “My comments, however, concern the risks of raising rates too
late. Such risks also can be significant but all too often seem more
distant and less compelling, and therefore hold great long-term danger
for us all.”

Hoenig was cautiously upbeat about the economic outlook, which he
called “generally good.”

“A number of indicators suggest the economy has begun to recover
and is expanding at a steady pace since hitting bottom last summer,” he
said, adding that he expects GDP growth of about 3% for 2010.

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