Aug. 21 (Bloomberg) -- Federal Reserve Bank of Richmond President Jeffrey Lacker said the impact of ``financial turbulence'' on the broader economy will determine decisions on interest rates.

``Financial market volatility, in and of itself, doesn't require a change in the target federal funds rate,'' Lacker said at a luncheon of the Risk Management Association of Charlotte. ``Interest-rate policy needs to be guided by the outlook for real spending and inflation,'' and markets can change that assessment if they induce changes in growth or prices.

Lacker is the first Fed official to provide a detailed analysis of the economic and policy implications of the global market tumult that has spread beyond defaults and delinquencies in mortgage markets. His comments suggest he supports the Federal Open Market Committee's approach, which has addressed liquidity needs with policy tools other than the benchmark federal funds rate target.

On Aug. 17, the Fed cut the discount rate, on direct loans to banks, in an effort to increase the availability of capital as investors shun assets linked to subprime mortgages. Policy makers pledged ``to act as needed'' to ease the impact of market turbulence on the economy.

`Tools' Available

Lacker's speech followed a meeting by Fed Chairman Ben S. Bernanke with Senate Banking Committee Chairman Christopher Dodd today on Capitol Hill. Bernanke agreed to use ``all of the tools at his disposal'' to restore stability in financial markets, Dodd, a Connecticut Democrat seeking his party's presidential nomination, told reporters.

The FOMC said last week that ``the downside risks to growth have increased appreciably,'' reversing its stance Aug. 7 that inflation was the greatest risk. Policy makers kept the benchmark rate at 5.25 percent, where it's been since June 2006.

``Sound discount window policy, I believe, should aim at supplying adequate liquidity without undermining the market's assessment of risk,'' Lacker said.

Lacker said that tighter credit conditions have the potential to exert a further drag on overall growth by deepening the housing recession.

Delinquencies on loans to borrowers with limited or poor credit histories hit a five-year high in the first quarter, and builders started work on the fewest homes in a decade in July.

`Dampened' Optimism

``Recent data on actual housing market activity have dampened my optimism'' about a bottoming-out in the industry, Lacker said. Tighter credit conditions ``could further dampen residential investment.''

Consumer spending and business investment should offset real-estate markets, Lacker said. He also noted that labor markets are ``tight'' and prospects for income growth are ``pretty good.''

``I expect overall growth to come in somewhat below its long-term trend for the remainder of the year,'' the Richmond Fed president said. ``The drag from housing will continue for some time.''

Fed officials don't expect to know for some days whether their Aug. 17 action will work in stemming liquidity shortages in credit markets. Because banks are more cautious about the collateral they accept for loans, it will take some time for market participants to settle on appropriate prices for riskier assets.

Market Stress

While stocks have recouped some of the month's losses since the Fed's decision, the market for asset-backed commercial paper remains unsettled. U.S. Treasury securities also continue to climb as investors seek a haven in the safest debt.

Lacker has developed the toughest stance against inflation among Fed officials since taking office in 2004. He alone voted to raise the benchmark target rate for overnight loans between banks in the last four meetings of 2006.

He continued to cite inflation risks in his remarks.

``While the most recent months' figures have been encouraging, it is still too soon to be confident that the moderation we have been seeing represents a downward trend'' in inflation, he said. The risk that inflation will fail to moderate ``is still relevant, although some recent reports have been encouraging,'' he said.

The Fed's preferred price gauge, which excludes food and energy costs, rose 1.9 percent in the 12 months to June, the smallest gain in three years. Inflation has slowed for four straight months.

``As events continue to unfold, I will be watching for signs that changes in the cost of credit might be having broader effects on spending than we have seen or seem likely so far,'' Lacker said. ``I will also continue to monitor the indicators of inflation and inflation expectations.''

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net Steve Matthews in Charlotte at smatthews@bloomberg.net

Last Updated: August 21, 2007 13:06 EDT