Philadelphia Federal Reserve President Charles Plosser said on Tuesday he is cautiously optimistic that the U.S. economy will start to grow again in the second half of 2009, breaking out of a lengthy recession.

Plosser, one of the Fed's biggest inflation hawks, said the central bank needs to get out ahead of a potential inflation spike as the economy recovers, even if the jobless rate is still rising at the time.

Unemployment is a lagging economic indicator. The economy is going to turn around long before unemployment rates peak, Plosser told reporters after a speech at the University of Chicago Booth School of Business.

There will come a time when we have to start raising rates and draining all this liquidity, and there are some parts of the marketplace ... that may not be fully recovered yet. We will need to do that.

In the past, and in the 1970s in particular, the Fed has sometimes been too slow to start tightening its policy after an economic downturn, Plosser said.

Once that process (of recovery) starts we need to get out in front of it, otherwise we could be faced with lots of inflation down the road.

The Fed will also need to brace for pushback from several directions when it starts to dismantle its alphabet soup of lending programs, Plosser said. Various interest groups are likely to cry foul, saying markets are too fragile or the economy still too weak, he cautioned.

Such pressures could threaten the Fed's independence to control its balance sheet and monetary policy. We will need to have to fortitude to make some difficult decisions.


Plosser told reporters he was surprised that the market seemed taken aback when the Federal Open Market Committee said in March it would buy longer-term Treasury debt, after foreshadowing such a move for a couple of months.

Treasury purchases create more flexibility for the Fed's balance sheet and would be easier and less disruptive for the central bank to sell when the time arises than purchases in individual asset classes, said Plosser.

Longer-dated issues also give more bang for the buck when short-term rates are near zero bound, he said.

The FOMC has set its target fed funds rate in a range of zero to 0.25 percent since December. Financial markets bet that rates will stay near zero for the rest of 2009.

While Plosser endorsed purchases of Treasuries, the Fed is also in the process of buying more than $1 trillion in mortgage-backed securities, many of which will not roll off its balance sheet for years.

That program, and a separate plan to buy large amounts of asset-backed securities with maturities of three years or more, underline the problems of the Fed's balance sheet drawdown, Plosser said.


Plosser and Minneapolis Fed President Gary Stern both urged a fresh focus on the issue of too big to fail, in which certain banks or financial institutions are kept afloat because their demise is seen as a trigger for massive systemic risk.

The policy-makers agreed, though, that a knee-jerk swing to over-regulation was not the answer.

A truly draconian regulatory regime could conceivably succeed in diminishing risk-taking, but only at excessive cost to credit availability and economic performance, Stern said in a speech to the Brookings Institution in Washington.

Years of inaction dramatically raised the economic costs of the U.S. financial crisis, said Stern, who has urged more attention to the TBTF issue for several years.

Policy-makers did not prepare for the 'too big to fail' flood; indeed, they situated themselves on the flood plain, ignored the flood warning, and hoped for the best, he said.

Looking ahead, Plosser said the policy goal should not be to try to prevent every failure, but to reduce the systemic risks to the financial system that a failure may create.

He also warned against suggestions that the Fed become the U.S. financial system's uber-regulator, saying that an overly vague or sweeping mandate puts the central bank's credibility at risk and threatens core monetary policy objectives.

(Additional reporting by Mark Felsenthal in Washington; Editing by Dan Grebler)