The Federal Reserve can continue raising interest rates at a measured pace, but with less slack in the U.S. economy, it must be vigilant on inflation, Chicago Fed President Michael Moskow said on Wednesday.

"Now that the expansion is solidly in place, the issue of inflation becomes increasingly important," Moskow, a voting member of the Fed's policy committee this year, said in prepared remarks to the Investment Analysts Society of Chicago.

"The current level of output is only modestly below the level of potential output." he said, adding that the current jobless rate of 5.4 percent might understate the amount of slack in the labor market, but not by much.

Last Friday's February payrolls report confirmed that employment growth continues at a solid rate, Moskow said.

Rising work force participation would provide a partial buffer against "shortages and bottlenecks often associated with rising inflation," he said.

Even so, the U.S. labor force was unlikely to return to very high participation levels last seen in 2000 for a number of reasons, he said.

As U.S. crude oil futures approach record highs, Moskow said, inflation could have a temporary spike and be elevated for some time as higher energy prices work through the economy.

Futures prices for delivery up to five years ahead indicate that oil prices are expected to remain well over $40 per barrel, he noted.

Although there is little evidence that long-run inflation expectations have risen as yet, the Fed is "prepared to act" if price pressures accelerate, Moskow said.

The Federal Open Market Committee is expected to raise benchmark interest rates by 25 basis points at its March 22 meeting, continuing a tightening cycle started in June, and to continue to boost rates at least through mid-year.

The Federal funds rate has risen to 2.5 percent from its 1958 low of 1.00 percent after six consecutive FOMC rate increases.

Moskow said most people peg a neutral rate -- one that neither promotes nor inhibits growth -- in the 3.5 percent to 5 percent range for the nominal rate but declined to be more specific.

"There is certainly more ground to cover" to get rates back to neutral, he said. "I can't say precisely what it (neutral) is."

On Tuesday Fed Gov. Ben Bernanke said the neutral fed funds rate may be lower today than in the past. Some studies have placed the neutral real rate at about 2 percent.

NOT A FAN OF INFLATION TARGETING

Unlike several of his FOMC colleagues, the Chicago Fed chief said he was "cautious" about inflation targeting, terming it a concept more useful in countries that have had inflation crises.

"Inflation targeting is not something you can move into right away," he told reporters after the speech. Studies have shown "no evidence" that inflation targeting is helpful, Moskow added.


Fed Chairman Alan Greenspan does not favor inflation targeting, but some Fed officials have said that it would make the Fed's thinking more transparent and contribute to price stability.

The Fed's policy-making group discussed targeting as a special topic at its last meeting in early February.

Core personal consumption expenditures, the Fed's favored inflation measure, rose 1.5 percent in 2004. The core PCE probably overstates inflation a little, Moskow said.

Moskow took up a familiar theme of the Fed, terming the huge U.S. current account deficit "unsustainable."

Now at about 6 percent of gross domestic product, the deficit "cannot rise indefinitely," he said. Over time, the lower U.S. dollar should start to correct the deficit, and a higher national savings rate would help as well, Moskow said.

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