Jan. 11 (Bloomberg) -- Federal Reserve Bank of New York President Timothy Geithner said the pattern of large foreign central bank purchases of dollars that is holding down U.S. interest rates will prove ``transitory.''

``Very substantial official accumulation of dollar reserves'' masks the impact that U.S. budget and trade deficits would otherwise have on interest rates, he said. He urged policy makers to reduce the budget gap and endorsed the restoration of fiscal rules requiring new tax cuts or spending to be offset.

``These forces are almost certainly transitory, but their impact on capital flows, interest rates and asset prices are likely quite important,'' Geithner said in a speech in New York. ``If they are large enough, they have the potential to alter or distort current decisions about investment and consumption in a way that could be detrimental'' to long-term growth, he said.

Ten-year Treasury yields have averaged 4.38 percent since the start of 2002, a period when the budget slid into deficit, down from 5.48 percent in the previous four years of surpluses. Foreign official holdings of Treasuries more than doubled since 2002, to $1.32 trillion in October, Treasury data show.

Geithner, speaking at the Council on Foreign Relations, didn't comment on the outlook for U.S. monetary policy.

Inflation Target

Asked about potential adoption by the Fed of a public, numeric inflation goal, Geithner said any decision wouldn't conflict with the central bank's legal requirements to achieve stable prices and maximum employment. Barney Frank, the new chairman of the House Financial Services Committee, opposes any attempt to narrow the Fed's mandate to inflation alone.

``There's no conflict necessarily between the legislative mandate we have now in the United States for the governors of the central bank and the range of possible variants of the inflation targeting frameworks other countries have adopted,'' Geithner said.

The need to reduce the budget gap is especially important because the U.S. current-account deficit has reached an ``unprecedented'' level of 7 percent compared with gross domestic product, Geithner said.

The gap in the current account, the broadest measure of trade because it includes transfer payments and investment income, widened to a record $225.6 billion in the third quarter as the trade gap deepened and the country paid more interest to overseas investors.

Central Banks

Foreign central banks have accumulated holdings of dollars as they manage their currencies and record rising trade surpluses with the U.S. China, which limits movements in its currency to 0.3 percent a day, has reserves of about $1 trillion.

International investors hold about half of the $4.3 trillion of marketable Treasuries outstanding, according to monthly figures from the U.S. Treasury.

Large global imbalances ``will have to come down over time,'' said Geithner, who was director of policy development at the International Monetary Fund before joining the Fed. Reducing the U.S. budget deficit ``is important to raising the probability that this process of adjustment unfolds with less risk.''

Emerging markets have reduced their vulnerability to financial and exchange-rate crises by improving monetary and fiscal policies, he said. At the same time, the practice of a number of countries of continuing to link currencies with the dollar has ``less favorable implications'' for financial risk.

Currency Pegs

``A substantial part of the world economy runs exchange rate regimes tied in some way to the dollar, or directed at minimizing changes relative to the dollar,'' he said.

Geithner helped coordinate U.S. policy at the Treasury during the Asian financial crisis in 1997, when countries including Thailand were forced to devalue their currencies after maintaining pegged exchange rates.

The risks to the dollar's global role ``probably come from us, not from broader change in the world,'' underscoring the need for improved U.S. economic policy, Geithner said in response to a question.

Geithner, 45, a former Treasury undersecretary for international affairs who became the New York Fed's president in 2003, said that restoring fiscal rules that require tax cuts or new spending to be offset in some way ``will help reduce the risk of further deterioration'' in the budget deficit.

The Democrat-led House of Representatives voted on Jan. 5 to approve rules that make it more difficult for lawmakers to cut taxes or increase some government spending, known as pay-as-you- go rules.

Commitment to fiscal discipline ``looks like it's getting traction again,'' Geithner said, without specifying whether he favored the Democrats' particular bill.

Protectionism

Geithner also cautioned against the rise of protectionism, saying that sustaining support for global economic integration ``may be the most important economic challenge of our time.'' That will be ``more difficult'' in the U.S. because income inequality and slow wage growth among the middle-class, he said.

Geithner said separately that international regulators are examining how banks lend to hedge funds. While banks' total credit exposure is not ``large,'' regulators are seeking a more ``conservative'' lending environment, he said in answer to a question.

``You want to worry a little bit'' about the extent of leverage given the increased use of new securities such as credit derivatives, Geithner said.

The collapse last year of hedge fund Amaranth Advisors LLC was a ``special'' case and not necessarily the best model for showing how resilient financial markets are when hedge funds run into trouble, Geithner he also said.

In the U.S., the increase in productivity, or the amount workers produce per hour, recorded in the late 1990s probably won't abate, Geithner said, echoing remarks in August by Fed Chairman Ben S. Bernanke. ``The acceleration in productivity growth that occurred in the United States in the second half of the last decade seems likely to remain intact,'' Geithner said.

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

Last Updated: January 11, 2007 10:45 EST