Fed's Lockhart - Now not the time to be tentative

Early summer storm clouds gather over the U.S. Federal Reserve Building in Washington June 9, 2006.

PALM BEACH, Fla. (Reuters) - The Federal Reserve can operate with zero interest rates if it has to and the U.S. recession will get worse before recovering in the second half of next year, a top Fed policy-maker said on Friday.

"Now is not a time to be tentative," Atlanta Fed President Dennis Lockhart told a business luncheon.

"The U.S. economy in September and October appeared to weaken dramatically ... Problems are now broad-based," said Lockhart, who will be a voting member of the Fed's interest rate-setting committee in 2009.

The United States was already in recession, he said, adding that growth in the fourth quarter may notch a steeper decline than the 0.3 percent annualized fall of the previous three months.

Lockhart also told the luncheon, hosted by the Business Development Board of Palm Beach County, that the Fed had not exhausted its ammunition.

"There are still many measures that can be taken if required," he said.

"In theory, we could go to zero (interest rates)," he said in response to a question from the audience. "You can operate monetary policy at zero by injecting liquidity into the system and in effect separating the interest rate from the liquidity measures that you've picked, so that's a possibility."

Palm Beach, and south Florida in general, have some of the highest levels of mortgage failure in the country.

Since September 2007, the Fed has slashed interest rates by 425 basis points to 1 percent and pumped over $1 trillion of liquidity into the financial system to offset a global credit crisis stemming from the U.S. housing sector's collapse.

Interest rate futures currently imply another half point cut to 0.50 percent in the Fed's benchmark overnight funds rate at its next scheduled policy meeting on Dec. 16.

Interest rate futures were also reflecting concern following very gloomy jobs data on Friday that showed U.S. unemployment jumped to a 14 year high of 6.5 percent in October from 6.1 percent in September. Lockhart warned this trend would continue in the months ahead.

"I foresee substantial weakness at least through the first half of 2009. This weakness will exacerbate the employment picture. In my outlook, unemployment will rise some more," he said in the speech.

Lockhart stressed that two things must happen before the cumulative impact of the Fed's policy measures made themselves properly felt on the economy.

"First, U.S. house prices need to stop falling and the volumes of defaults and foreclosures needs to stop rising ... Second, deleveraging of the financial system must run its course," he said.

He later told reporters the deleveraging process appeared to be well advanced, but still had some distance to run.

Lockhart said that market conditions might have eased in recent days but it was premature to declare the crisis past.

"There have been signs of improvement lately, but concern persists that this is a false dawn and more trouble could lie ahead," he said.

But he stressed that policy-makers would prevail and that U.S. growth should pick up in the final six months of 2009.

"I think a recovery will come. I think we will begin to see signs of economic recovery in the second half of next year, perhaps earlier. We've already seen signs of improvement in the credit markets and that is very encouraging."

In addition, the Fed does not have to worry much about inflation amid such clear evidence of economic problems.

"As a result of the widespread weakness in the U.S. economy, inflationary pressures appear to be declining," he said.

The Fed significantly lowered its inflation warning in its statement announcing a half percentage point rate cut on Oct. 29, which investors have taken as a sign of more easing ahead.

(Additional reporting by Mark Felsenthal, Editing by Chizu Nomiyama )