The ballooning U.S. budget deficit and growing mountains of federal debt will increase pressures on the Fed to hold interest rates low and make it harder to avoid inflation, a senior Federal Reserve official said on Tuesday.
The current outlook for fiscal policy poses a threat to the Federal Reserve's ability to achieve its dual objectives of price stability and maximum sustainable long-term growth, and therefore is a threat to its independence as well, Kansas City Federal Reserve President Thomas Hoenig said in remarks prepared for delivery to the Peterson-Pew Commission on Budget Reform.
Fiscal policymakers should opt for the difficult path of cutting spending and increasing revenues in order to rein in deficits, Hoenig said. U.S. fiscal policy must focus on reducing the debt buildup and its consequences, he said.
A debt rating agency said earlier this month that high U.S. budget deficits could put the country's top-level debt rating at risk. While the Obama administration's recently announced budget proposal would take a small step toward sustainable debt levels, more is needed to preserve the country's Aaa rating, Moody's Investors Service said.
Hoenig also said the suggestion by economists at the International Monetary Fund that central banks tolerate higher levels of inflation than they have in the past to gain more power to counteract economic shocks is worrisome and would send the economies down the wrong path.
An IMF staff paper released on Friday suggested that policymakers might consider raising their inflation target to 4 percent from 2 percent to allow monetary policy to be more effective in future deflationary crises.
The Kansas City Fed president, who is a voter this year on the Fed's interest rate-setting panel, said high debt will tempt politicians to push the Fed to print money to bridge budget shortfalls.
Such an approach has historically lead to major inflation, Hoenig said.
The Fed pumped more than $1 trillion into the U.S. economy to continue to help the economy after it had cut interest rates to near zero. Many -- including Hoenig -- worry the massive amount of cash in the financial system will fuel runaway inflation when the economic recovery gains strength.
The Fed has said the weak economy needs the support of low rates and a financial system flush with money and that it has the tools to remove those supports when economic growth gains traction.
Hoenig dissented in January against the Fed's decision to continue to promise that it would hold interest rates exceptionally low for an extended period. Hoenig said he believes the economy has recovered sufficiently for the Fed to remove that pledge.
(Reporting by Mark Felsenthal, Editing by Andrea Ricci)