Fed's Kohn says risks of inflation psychology higher

By Pedro Nicolaci da Costa

HARWICH, Massachusetts (Reuters) - A steady rise in energy prices has fueled an inflationary psychology in the United States and could be a problem if it does not reverse, Federal Reserve Vice Chairman Donald Kohn said on Wednesday.

"Repeated increases in energy prices and their effect on overall inflation have contributed to a rise in the year-ahead inflation expectation of households," Kohn said in remarks prepared for delivery to a conference organized by the Boston Federal Reserve Bank on Cape Cod.

Kohn said evidence that longer-term inflation expectations have edged up is a particular worry.

"Any tendency for these longer-term inflation expectations to drift higher or even fail to reverse over time would have troublesome implications for the outlook for inflation," he said.

The surge in the price of oil since 2003 poses challenges for policy-makers as they pursue their goals of ensuring low unemployment and stable prices, Kohn said.

"An appropriate monetary policy following a jump in the price of oil will allow, on a temporary basis, both some increase in unemployment and some increase in price inflation," he said.

The Fed has lowered interest rates to 2 percent from 5.25 percent since September to put a floor under an economy battered by the collapse of housing markets and a credit crunch. However ,surging energy and commodity prices have raised fears of inflation in the United States and elsewhere.

Kohn's remarks come as average gas prices in the United States rise above $4 a gallon for the first time, and as European central bank officials signal they will raise interest rates to combat price pressures.