Fed's Lacker: Fed cash flood poses inflation risks

By Mark Felsenthal

LINTHICUM, Maryland (Reuters) - The Federal Reserve's dramatic dumping of money into the economy poses inflation risks down the road, and the central bank may need to raise interest rates before credit markets have completely recovered, Richmond Fed President Jeffrey Lacker said on Friday.

"While at the present time, credit programs do not conflict with our monetary policy strategy, there could well come a time at which monetary stimulus needs to be withdrawn to prevent a resurgence in inflation, even though credit markets are not deemed fully healed," he told the Maryland Bankers Association.

Lacker, one of the toughest anti-inflation hawks among senior Fed officials, cautioned that the U.S. central bank is mixing monetary policy with credit policy as it offers loans to stabilize financial markets in deep disarray after the housing market crash and the surge in mortgage defaults.

The Fed has cut interest rates to near zero and pumped hundreds of billions of dollars into the economy to restore lending and stimulate economic activity. In so doing, the central bank's balance sheet has expanded from near $900 billion in mid-2008 to over $2 trillion, and policy-makers have pledged to grow the balance sheet further if needed to pull the economy out of recession.

Lacker, in comments that highlight tensions at the Fed, warned expansion of the Fed's balance sheet may be risky.

"Credit policy is also aimed at promoting growth, but it is more a form of fiscal policy in that it uses the public sector's balance sheet to alter the allocation of resources," Lacker said.

"Many historical instances of monetary instability have been the result of central banks being prevailed upon to use their balance sheets for fiscal ends in ways that impeded their ability to keep inflation under control," he said.

The Fed in December considered, but set aside, a plan to set targets for the size of bank reserves or the monetary base.