Phila. Fed chief urges rate increase

The Federal Reserve should raise interest rates to prevent "the kind of wage-price spiral" that boosted prices and slowed the economy in the 1970s, Charles I. Plosser, president of the Federal Reserve Bank of Philadelphia, said yesterday in a speech burnishing his reputation as a leading Fed inflation hawk.

Plosser wants his colleagues on the Fed's Open Market Committee to boost the price of money.

Ironically, his warning came on a day when oil prices - a key reason inflation is spreading across the economy - fell more than $3 a barrel to the lowest in more than a month.

Also yesterday, the government said home prices fell sharply in May, and Treasury Secretary Henry M. Paulson Jr. urged Congress to act quickly to support mortgage finance companies Freddie Mac and Fannie Mae - and thus bolster the slumping housing market.

The administration's package to help Fannie and Freddie could cost taxpayers as much as $25 billion, the Congressional Budget Office estimated in an analysis released yesterday.

But Plosser's concern is rising prices.

The Federal Reserve between September and April cut the key federal funds rate to 2 percent from 5.25 percent to ease stress on the banking system as home foreclosures soared, loan markets shriveled, and Wall Street funds that buy and sell loan-backed bonds lost big.

"Inflation is already too high and inconsistent with our goal of price stability. We will need to reverse course," Plosser told a business audience at a restaurant at the King of Prussia mall.

"The reversal will need to be started sooner rather than later," he added, "and I believe it will likely need to begin before either the labor market or the financial markets have turned around."

Plosser said the Fed could afford to boost rates because the economy was showing signs that it was doing better than expected.

In question-and-answer sessions after his prepared remarks, Plosser said the Philadelphia home market "is in reasonably good shape" compared with high-priced markets that have collapsed in California, Florida and Las Vegas, and recession-wracked pockets of the industrial Midwest.

"I wouldn't say it's booming," but home values are stable here, he said, "except for the Jersey Shore," where inflated prices have been falling.

What about jobs? "Unemployment is going to continue to rise between now and the end of this year. We will have to raise rates before unemployment peaks."

The Fed has two missions, which sometimes conflict, Plosser said: "We have to keep the financial system functioning" by helping banks stay in business, which implies low interest rates, while also "ensuring financial stability" by fighting inflation, which means higher rates. At 2 percent, Fed money today is so cheap that "real interest rates are negative," he said; cheap funds will spur inflation in the months ahead if the Fed doesn't act.

Plosser is betting that high energy prices, the weak dollar, and other volatile prices won't stay at current levels, because extreme prices usually "end up reversing themselves."

He's more worried that high prices, spurred by easy money, will bring on 1970s-style inflation by spreading to other products and services, weakening the Fed's restraining influence as workers and suppliers start boosting prices to keep ahead of rising costs.

The proposed Fannie Mae/Freddie Mac rescue plan, Plosser said, "is the consequence of creating institutions that create moral hazard." Fannie and Freddie enjoy taxpayer guarantees, so they funded too many bad home loans.

"They took on extra risk because they had this backstop," he said. "Some would argue we should never do that."

The Fed has crossed an invisible border by setting up a fund to help investment banks, instead of confining itself to business and consumer lenders. Plosser said the "unprecedented" expansion of the Fed's mission raised tough questions.

"At some point, there will have to be a decision: Do these go away? Or will there have to be a legislative solution? The Federal Reserve is not intentionally seeking to extend its powers."

He added, "We're making many changes in the heat of battle. I hope we can be careful and analytical."

Plosser said inflation was high this year because of food, energy and other commodity costs; take that out, he said, and inflation isn't that high.

Yesterday's other developments:

Oil prices. Light, sweet crude for August delivery fell $3.09 to settle at $127.95 a barrel on the New York Mercantile Exchange. It was crude's fourth decline in the last five trading sessions.

The key to yesterday's drop: Tropical Storm Dolly grew increasingly unlikely to threaten oil supplies.

There also was a new indication that high oil prices were killing off demand, especially in the United States, the world's largest oil consumer. In its weekly pump-spending survey, MasterCard found U.S. gasoline demand dropped last week for the 13th week in a row.

Home prices. A government report said U.S. home prices fell a record 4.8 percent in May from the same month last year. The Office of Federal Housing Enterprise Oversight also said prices, on a seasonally adjusted basis, fell 0.3 percent from April to May.

The agency oversees the government-sponsored mortgage-finance companies Fannie Mae and Freddie Mac. The oversight agency's price index is calculated using mortgage loans bought or guaranteed by Fannie or Freddie.

Federal rescue. Paulson, the Treasury secretary, said it was critical for Congress to move rapidly to approve the support package for Fannie Mae and Freddie Mac because of the important role the two institutions play in financing almost half of the home mortgages in the country.

He said Congress' approval, which he predicted would come this week, would be "central to the speed with which we emerge from this housing correction," because it would guarantee the continued flow of mortgages to qualified home buyers.

The Bush administration unveiled a plan July 13 to provide unlimited government loans to the two mortgage giants and to purchase stock in the two companies if needed.