Nov. 28 (Bloomberg) -- Federal Reserve Vice Chairman Donald Kohn said market ``turbulence'' may reduce credit to businesses and consumers, reinforcing investors' expectations the central bank will cut interest rates again next month.

``The degree of deterioration that has happened over the last couple of weeks is not something that I personally anticipated,'' Kohn said in response to a question following a speech to the Council on Foreign Relations in New York. ``We are going to have to take a look at'' the stress in credit markets ``when we meet in a couple of weeks,'' he said.

Kohn's remarks are a shift from the Federal Open Market Committee's Oct. 31 statement, reiterated by Chairman Ben S. Bernanke a week later, that risks between growth and inflation were ``roughly'' balanced. Stocks jumped after the comments and the dollar pared gains against the euro.

Kohn ``has just given the markets the green light for a rate cut on Dec. 11,'' said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ in New York. ``Restrictive credit costs will very likely lead to a dramatic slowing of the economy if the Fed doesn't take steps to forestall them.''

The Standard & Poor's 500 Index rose 2.9 percent to 1469.02 at the close in New York.

Beige Book

Seven of the Fed's 12 district banks reported slowing growth in the central bank's latest Beige Book regional business survey. The report, published today, found retailers were ``slightly pessimistic'' about year-end holiday sales.

Federal funds futures indicate a 100 percent probability of a reduction in the benchmark interest rate, by at least a quarter point to 4.25 percent, when the FOMC meets Dec. 11. Barclays Capital economists changed their call after the Kohn speech, now expecting rate cuts in both December and January.

``We need to take account of those market expectations, but not follow them blindly,'' Kohn said in response to a question.

Kohn said ``uncertainties'' about the economic outlook are ``unusually high'' now, requiring policy makers to be ``flexible and pragmatic'' in setting policy. Existing home sales fell 1.2 percent in October to an annual rate of 4.97 million, the National Association of Realtors said in Washington. Orders for durable goods fell 0.4 percent last month, the Commerce Department said in a separate report.

His remarks were also different in tone from some regional Fed bank presidents, who have expressed concern that continued rate reductions may fuel inflation expectations.

Plosser, Evans

Philadelphia Fed President Charles Plosser said in a speech in Rochester, New York, yesterday that further rate cuts could ``exacerbate'' moral hazard problems and raise inflation risks. Chicago Fed President Charles Evans said monetary policy was properly calibrated to achieve both full employment and low inflation in separate remarks yesterday.

``While this speech is far from a smoking gun for easing in December, it says that one member -- and an influential one at that -- is paying attention to the market turbulence and will be open to easing if the stresses don't let up,'' Edward McKelvey, senior U.S. economist at Goldman Sachs Group Inc. in New York, said in a note to clients.

Risk spreads on financial instruments have increased since the Fed met Oct. 30-31, an index tracked by Citigroup Global Markets Inc shows. The index rose to a high of 0.99 on Nov. 22 from 0.77 on Nov. 1, with 1 being the highest level of risk aversion.

``We will need to assess the implications of these developments, along with the vast array of incoming information on economic activity and prices, for the future path of the U.S. economy,'' Kohn said, referring to heightened market stress.

Housing Surprise

Kohn also indicated that the continued deterioration in housing markets, now the worst recession in 16 years, have surprised him.

``The housing sector has continued to decline and to erode at a very, very rapid rate,'' Kohn said in response to a question. ``It would be nice to see some early signs that it was beginning to stabilize, and we haven't seen that yet.''

Merrill Lynch & Co., Citigroup Inc. and other banks that underwrote so-called collateralized debt obligations linked to mortgages and other credits have already warned of losses of at least $47.2 billion on CDOs and other holdings. The securities slid as investors shunned assets linked to subprime U.S. mortgages following a surge in loan defaults.

``There's further to go'' in revealing losses, Kohn said today. He added that the more information that is made public about potential losses ``the better,'' as it will help ease uncertainty.

Credit Losses

Concern about the ultimate extent of writedowns have caused investors to flee bank stocks and bonds, and kept lending rates between banks above historical averages. Losses on CDOs at the world's biggest banks may double to $77 billion, JPMorgan analysts estimate.

``Heightened concerns about larger losses at financial institutions now reflected in various markets have depressed equity prices and could induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses a well,'' Kohn said.

He added that a ``broader repricing of risk'' that increases the cost of credit and discourages spending ``would require offsetting policy actions, other things being equal.''

Banks are trying to shore up their capital as analysts predict additional mortgage losses in 2008. Citigroup Inc., the biggest U.S. bank, agreed to sell as much as 4.9 percent of the company to the government of Abu Dhabi for $7.5 billion. Freddie Mac, the second-largest purchaser of American mortgages, plans to sell $6 billion in preferred stock and halve its dividend.

Aiding Liquidity

Kohn noted that the short-term funding markets for banks remain under stress. Policy makers have responded, first lowering the charge on direct loans to banks in August, then reducing its main rate the past two months. The Fed this week also committed to a series of long-term repurchase agreements through year-end to ease funding shortages.

Still, central banks ``need to give some thought to how all their liquidity facilities can remain effective when financial markets are under stress,'' Kohn said.

Since Sept. 18, the federal funds rate has been reduced by 75 basis points. The Fed also cut the cost of direct loans from its discount window by 50 basis points in an unscheduled meeting Aug. 17 to address the liquidity needs of banks. A basis point is 0.01 percentage point.

Greenspan Adviser

Kohn, 65, was director of the Fed's Monetary Affairs Division and special adviser on monetary policy under former chairman Alan Greenspan before joining the board.

Kohn said labor markets remain strong, which provides an important ``pillar'' for the economy. ``On the other side, the spending data have been maybe a little on the soft side,'' Kohn said. ``There has been a noticeable slowing in the growth of consumption.''

Fed officials forecast prices will rise 1.8 to 2.1 percent next year. Kohn said inflation risks remain a priority for the committee.

Among private economists, the number anticipating a recession almost doubled in the past two months, the National Association for Business Economics said last week.

The Fed will release its regional survey on the economy known as the Beige Book at 2 p.m. today. Bernanke speaks on the economy tomorrow.

To contact the reporters on this story: Craig Torres in Washington at 1220 or ctorres3@bloomberg.net; Anthony Massucci in New York at amassucc@bloomberg.net.

Last Updated: November 28, 2007 16:49 EST