By Ros Krasny
NASHVILLE, Tenn (Reuters) - The Federal Reserve will not allow its unorthodox policies to lead to a surge in inflation, but may need to do more to ease credit if the economy fails to respond to stimulus measures, the Fed's No. 2 official said on Saturday.
But even with U.S. economy now in its sixth quarter of recession, Donald Kohn, vice chairman of the Federal Reserve, said the central bank's attempts to heal ailing credit markets and spur an economic recovery have been working, in ways that include lowering mortgage interest rates.
"The situation in financial markets and the economy would have been far worse if the Federal Reserve hadn't taken the actions we did," Kohn told a conference at Vanderbilt University in Nashville.
As the economy begins to recover, suitable policy responses by the Fed will prevent a rise in inflation, he said.
"The key to preventing inflation will be reversing the programs, reducing reserves, and raising interest rates in a timely fashion," Kohn said.
He emphasized the importance of inflation expectations in holding down future inflation.
"If expectations are not anchored -- if they vary in response to our actions or to persistent gaps between actual and potential output -- inflation itself will follow," he said.
On Friday, a survey-based forecast of one-year inflation expectations, from the University of Michigan, jumped surprisingly to 3 percent in April from 2 percent in March.
Kohn said the policy-setting Federal Open Market Committee is still mulling the value of setting an explicit objective for inflation -- a step further than it went earlier this year, in publishing "longer-run" inflation forecasts.
At its January meeting, the FOMC said most participants saw a long-run inflation goal of 2 percent as appropriate.
SPARRING WITH VOLCKER
Kohn was quizzed about that goal by former Fed Chairman Paul Volcker, who is famous for halting runaway inflation in the U.S. economy in the 1980s by raising interest rates sharply.
Volcker questioned Kohn on how the Fed can talk about "price stability" in the same breath as a 2 percent inflation goal, arguing that the target should be lower.
But Kohn said a 2 percent goal would give the Fed more flexibility at times of economic shock, because real interest rates start off higher as the economic cycle turns down.
The parrying ended with Kohn saying to Volcker: "I'm not going to convince you, am I?"
Kohn, who did not discuss the economic outlook at length, said the current recession is "global and will require a global response."
A heavy reliance on U.S. consumer spending to power global growth "was never a sustainable response," he said, noting how "U.S. consumers are pulling back, obviously, and are going to be amassing savings by not spending."
Among other things, the Fed is considering including jumbo mortgage loans in its newest lending program, the Term Asset-Backed Securities Loan Facility -- a move that could bolster the upper end of the housing market.
INTERVENTIONS CAREFULLY CHOSEN
Kohn conceded that some Fed officials are uncomfortable with what is seen as selectively allocating credit across various markets, but said the interventions have been carefully chosen.
With the Fed's independence under threat from Congressional scrutiny, Kohn said the central bank would give Congress the additional information it seeks about its lending programs, and welcomed a review.
"The public is naturally interested in our lending practices, and we will be releasing even more information about what stands behind our loans in coming weeks," he said.
The FOMC has embarked on a process often known as quantitative easing since lowering its main monetary policy tool, the fed funds rate, to almost zero percent in December.
The central bank's balance sheet has been run up to some $2 trillion and is expected to go much higher.
"High levels of Federal Reserve assets and resulting reserves are likely to be essential to fostering recovery," Kohn said. The Fed has also discussed whether making explicit objectives on the size of its balance sheet would help to better communicate the Fed's thinking, he added.
(Additional reporting by Kristina Cooke; Editing by Leslie Adler)
