June 10 (Bloomberg) -- The Federal Reserve must avoid the risks of “waiting too long or moving too slowly” to tighten monetary policy once an economic recovery begins, Richmond Fed Bank President Jeffrey Lacker said.

“The challenge for us on the Federal Open Market Committee will be to shrink our balance sheet and tighten policy soon enough when the recovery emerges to prevent rising inflation,” Lacker said today, without specifying the timing of such a move. “The danger will be that we will not shrink our balance sheet enough when the recovery emerges.”

For now, growth prospects are “likely to warrant rates as low as they are for some time,” Lacker told reporters today following a speech in North Carolina. “But just how long is uncertain and hard to predict in advance.”

The central bank is buying as much as $1.75 trillion of housing debt and Treasuries this year to lower borrowing costs across the economy after reducing the benchmark interest rate to as low as zero in December. Total assets on the Fed’s balance sheet have expanded $1.18 trillion over the past year to $2 trillion. Fed officials plan to hold their next policy meeting June 23-24 in Washington.

“Right now, I don’t see a reason to increase” bond purchases, Lacker told reporters. “In fact, if anything, if yields are rising because of stronger growth, that would cut against the case for increasing purchases in my mind.”

Economy Shrank

The U.S. economy shrank at a 5.7 percent annual pace in the first quarter, capping its worst six-month performance in five decades. That followed a 6.3 percent tumble in the last three months of 2008. Fed officials forecast the economy will rebound with growth from 2 percent to 3 percent in 2010, according to their most recent projections made in April.

“While economic activity still is contracting overall, some spending components appear to be bottoming out and the overall rate of contraction is thus slowing,” Lacker said in the speech, to members of the North Carolina legislature in Raleigh. “If the emerging stability in housing and consumer spending persists, as I expect, some segments of business investment spending should bottom out by the end of the year and economic growth would then turn positive.”

Lacker, a voting member of Fed’s monetary policy committee this year, said that the rise in one- and two-year interest rates reflect expectations of how the central bank will change the overnight rate in the future. The “leading interpretation” of the rise in short-term rates is that it reflects “greater confidence of economic recovery and that we will raise interest rates sooner,” he said in response to a question.

‘Subsided Substantially’

He also noted that fears of deflation have “subsided substantially.”

Lacker said he is concerned about giving the Fed authority to issue its own debt. “I worry about giving the Fed the ability to use debt finance outside the congressional appropriations process,” he said. Bloomberg News reported yesterday that Fed officials still haven’t made a formal request to lawmakers for the authority to issue debt.

The economy will probably rebound before the unemployment rate peaks, the Fed district bank president said. U.S. payrolls fell by 345,000 jobs in May, the least in eight months. The jobless rate rose to 9.4 percent, the highest since 1983. The world’s largest economy has lost 6 million jobs since the recession began in December 2007, exacerbating the biggest drop in any post-World War II economic downturn.

‘Growth Process’

“The growth process needs to govern our rate decisions,” Lacker told reporters. “The growth process is more important to our rate decisions than the level or rate of change of the unemployment rate.”

Falling home prices, tighter lending standards and higher unemployment have made it difficult for homeowners to refinance or pay loans. The U.S. mortgage delinquency rate jumped to 9.1 percent in the first quarter up from 7.9 percent in the fourth quarter, according to the Mortgage Bankers Association.

Lacker said that financial innovation on mortgages was accompanied by “lax underwriting standards by many lenders, overly complex and opaque securitization and the expectation of future housing price appreciation by almost every borrower, lender, investor and analyst.”

The housing bust that resulted may be showing preliminary signs of turning, he said. “Single family housing starts hit a low in January and have risen slightly since then,” and some measures of home prices improved, he noted. “Housing activity is in transition, moving away from the rapid declines of recent years toward a bottoming-out process later this year.”

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net; Steve Matthews in Atlanta at 1310 or smatthews@bloomberg.net.

Last Updated: June 10, 2009 13:39 EDT