Fed's Plosser says asset sales wouldn't disrupt markets

Philadelphia Federal Reserve Bank President Charles Plosser said the U.S. central bank should start selling some of these assets sooner rather than later to avoid sowing the seeds of future inflation.

Despite recent volatility in markets due to fiscal deficit problems in Europe, financial markets are now functioning much better than they were during the height of the financial crisis, Plosser said in remarks prepared for delivery to the Blair County Chamber of Commerce.

I believe the Fed could begin to liquidate its positions gradually without market disruption.

The Philadelphia Fed chief said the U.S. economic recovery appears to be sustainable, with stronger business spending and moderate consumer spending growth.

He said he expects inflation to remain subdued in the near term, but warned that as the economic recovery takes hold the Fed must ensure price pressures stay under wraps.

In addition to buying mortgage-related debt, the Fed also cut benchmark interest rates to the bone to support an economy that was reeling from the worst financial crisis since the Great Depression.

The central bank has kept its target for the benchmark federal funds rate at near zero since December 2008 and has pledged to keep it there for an extended period.

If we do not exit from this strategy in a timely manner, we could be sowing the seeds of another round of uncomfortable and costly inflation in the intermediate term, he said.

Returning to a more normal monetary policy will involve ... returning to an all-Treasuries portfolio, and raising the short-term interest rate toward a more normal level, he said.

Plosser said even if the benchmark interest rate target was increased to 1 percent, policy would remain very accommodative.

But he did not go as far as his counterpart at the Kansas City Fed, Thomas Hoenig, who earlier this month made a bold call for the benchmark interest rate to be raised to 1 percent by the end of the summer.

Like Hoenig, Plosser is known as one of the more hawkish regional Fed presidents on inflation. He is not a voting member of the Fed's policy-setting committee this year,

Plosser reiterated that the Fed will have to begin tightening monetary policy well before the jobless rate has fallen to acceptable levels. The unemployment rate will decline only gradually, he said.

Plosser described the U.S. jobs report last Friday, which showed just 41,000 private sector jobs were created in May, as somewhat disappointing but cautioned not to read too much into one month's data.

As the economy strengthens and firms become convinced that the recovery is sustainable, hiring will pick up over the rest of this year and in 2011, he said.

Plosser said he expects inflation of around 2 percent this year and 2.5 percent next year and sees inflation risks in the medium to longer run.

Speaking as financial regulatory reform enters its final stretch in Washington, Plosser repeated his warning that changes that would curb the central bank's independence would harm the U.S. economy.

(Reporting by Kristina Cooke, Editing by Chizu Nomiyama)