Fed's Plosser: Default debate political, not economic

By Ana Nicolaci da Costa and Harpreet Bhal

LONDON (Reuters) - The debate over whether the United States should stage a mini-debt default is largely a political one, although action must be taken on the country's fiscal situation, a top Federal Reserve official said on Thursday.

An increasing number of U.S. Republicans do not believe the Obama administration's dire predictions of economic "catastrophe" if the U.S. debt limit is not increased, arguing that a period of technical default can be managed without plunging markets into chaos.

Asked what the Fed thinks about the debate on such a default, Philadelphia Federal Reserve Bank President Charles Plosser said: "I think from the political stance, the fact that the debt ceiling needs to be addressed provides leverage for both sides to try to bring the other side closer to their views.

"In that sense it's a political debate. It's really not about economics."

U.S. President Barack Obama and Republican lawmakers are engaged in a high-stakes standoff over raising the $14.3 trillion U.S. borrowing limit, which the administration says must happen before August 2 to prevent the United States from defaulting on its obligations.

Republicans are demanding budget cuts in exchange for the borrowing cap and a number have questioned whether a default would have the dire consequences Obama has said it would.

Another Fed official, St. Louis Fed President James Bullard, warned on Wednesday that the stalemate over the debt ceiling could turn into "a global macro shock" if not resolved.

The standoff between Obama and congressional Republicans is casting a shadow over the economic recovery, which has hit a temporary soft patch, Plosser said.

"The drama being played out in Congress over debt and spending has provided yet another source of uncertainty for the economy," Plosser said in prepared remarks to the Society of Business Economists in London.

The current fiscal situation in the United States is unsustainable and something needs to be done, he later said.

UPSIDE RISKS TO INFLATION

Plosser, a voter on the Fed's policy-setting Federal Open Market Committee and one of the more inflation-focused hawks on the panel, said recent weakness would give way to a moderate recovery and U.S. inflation would become a concern in 2012 and 2013.

"I believe that this weakness will likely prove to be a temporary soft patch and that the underlying fundamentals remain the second half of this year, and to strengthen a bit more next year," Plosser said.

The Fed cut benchmark borrowing costs to close to zero in December 2008 and is on track to complete the second of two asset buying programs.

Plosser reiterated his call for the Fed to adopt an inflation target that would secure faith in the monetary authority's commitment to price stability.

Signs the U.S. recovery may be flagging have pushed back the date financial markets expect the Fed to begin to pull back some of its easy money policies, put in place to pull the economy out of a painful recession and boost a sluggish recovery.

The end of ultra-loose monetary policy could be in sight if the economy returns to a growth path of 3 percent this year, Plosser said. He, like some others in the Federal Reserve, did not currently see the need for further bond purchases.

"The hurdle rate for me to support additional asset-purchases ... is quite high," Plosser said.

There would need to be "a financial crisis of some kind to justify that," he added.

Plosser has said the Fed could reverse easy monetary policy as early as this year and reiterated on Thursday that any exit should be well-communicated to avoid destabilizing inflation expectations.

The Fed should take steps early to pare its balance sheet, which has grown to about $2.7 trillion as a result its bond buying programs, back to near its pre-crisis levels of around $900 billion, Plosser said.

The U.S. monetary authority will need to sell assets from its balance sheet and shrink the volume of excess reserves banks hold at the Fed to a level that will allow the federal funds rate to trade above the interest rate the Fed pays on excess reserves, he added.

(Additional reporting by Mark Felsenthal, editing by Bernard OrrToby Chopra/Catherine Evans)