Sept. 10 (Bloomberg) -- Federal Reserve Board Vice Chairman Donald Kohn said a sharp increase in short-term interest rates is unlikely because of low inflation and a feeble world economy.

“With the global economy quite weak and inflation low, a large and rapid rise seems quite improbable,” Kohn said today at a conference at the Brookings Institution in Washington.

Kohn responded to warnings by a speaker at the conference that the Fed, while trying to stem the financial crisis, may jeopardize its budget surplus and political independence in the future. The central bank lowered its main interest rate almost to zero in December and has more than doubled its balance sheet by creating emergency credit programs.

The Fed may face “significant budget shortfalls,” leading to threats on its independence, because of an expanded balance sheet including “assets with risky returns,” Ricardo Reis, an economics professor at Columbia University, said in a paper for the conference.

Kohn called that outcome “extremely remote,” saying the Fed’s credit-loss exposure “is quite limited.” While higher short-term rates would increase the amount of interest paid on banks’ deposits with the central bank, the Fed will keep earning “substantial net income over the next few years,” in part because of “sizable earnings on our assets,” Kohn said.

Bailouts ‘Uncomfortable’

Responding to audience questions, Kohn indicated the Treasury Department may take over assets the Fed acquired in rescues of Bear Stearns Cos. and American International Group Inc., saying a March agreement to transfer the portfolios “is still in play.” The bailouts were “uncomfortable,” with the Fed taking on more credit risk than usual, Kohn said.

He said government power to wind down failing financial firms is “absolutely an essential piece” of potential legislation to overhaul regulation.

Reis said the Fed has “deviated from the theoretical recommendations by not making a clear commitment to have higher- than-average inflation in the future, and especially by not providing a clear signal that it will keep nominal interest rates low for some time even after the crisis is over.”

Kohn responded that “a policy of achieving ‘temporarily’ higher inflation over the medium term would run the risk of altering inflation expectations beyond the horizon that is desirable.”

“Were that to happen, the costs of bringing expectations back to their current anchored state might be quite high,” Kohn said. The Fed has tried to reduce private borrowing costs and prevent inflation expectations from falling to “undesirably low levels,” he said.

‘Extended Period’

In a footnote, Kohn repeated the stance of Fed policy makers that the central bank is unlikely to raise interest rates for an “extended period.”

He reiterated that the Fed will raise the rate paid on banks’ deposits as a main tool of tightening credit. At the same time, Fed officials are developing ways to “drain or neutralize large volumes” of the reserves, because such amounts “could have undesired effects on the portfolio decisions of banks,” Kohn said.

Kohn, 66, who joined the Fed in 1970, has been the central bank’s vice chairman since 2006.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net; Craig Torres in Washington at ctorres3@bloomberg.net.

Last Updated: September 10, 2009 18:37 EDT