OECD: Fed should begin to hike interest rates

By Pedro Nicolaci da Costa

WASHINGTON (Reuters) - The Federal Reserve should begin to hike interest rates in coming months, the Organization for Economic Cooperation and Development said on Wednesday, as it raised its outlook for U.S. economic growth.

In its semi-annual forecast, the OECD said it sees U.S. economic growth of 2.6 percent in 2011, up from its forecast last November for growth of just 2.2 percent.

The outlook, however, is much lower than the Fed's own "central tendency" estimates, which as of April 27 pegged growth for this year in the 3.1 percent to 3.3 percent range.

Despite what it sees as significant potential downside risks to expansion from higher energy and commodity prices, the OECD recommends the Fed begin slowly withdrawing some of its extraordinary aid to the economy as 2011 progresses.

"A modest reduction in monetary stimulus should get under way in the second half of this year," the OECD said in its report.

Alan Detmeister, the OECD Economics Department's U.S. desk officer, said in a press briefing the Fed should raise its benchmark federal funds rate to 1 percent from the current zero to 0.25 percent range before the end of the year.

Continued high levels of unemployment are not enough of a reason to keep rates at rock-bottom lows, the OECD said, since low rates raise the risk of future bubbles or inflationary shocks. The group predicts the U.S. jobless rate, currently at 9 percent, will remain close to 8 percent for much of 2012.

"At present there is little sign that continued extraordinarily loose monetary policy settings have increased inflation expectations more than a small amount or are resulting in another asset price bubble," the OECD added, citing oil and other commodities as a "possible exception."

The OECD expects the trend of subdued inflation to continue for the foreseeable future, predicting U.S. consumer price inflation of 1.9 percent for this year and just 1.3 percent next year -- well beneath the Fed's implicit target of 2 percent or a bit below.

The Fed looks set to complete its $600 billion bond-buying program aimed at keeping long-term rates down in June, as scheduled. Its balance sheet now stands at a record $2.74 trillion, but a large amount of bank reserves remain parked at the Fed rather than being lent out to businesses.

A LITTLE TOO LOOSE?

Still, the OECD's call for rate hikes, potentially controversial given a still-fragile U.S. recovery, appears to be based on the presumption that rates are so far below their normal levels that the tightening process must begin soon.

Detmeister believes a "neutral" U.S. benchmark rate that neither retards or stimulates growth should be around 4.5 percent.

"Tightening somewhat now would reduce the need for steeper, and potentially disruptive, increases in interest rates later," the OECD said.

At the same time, the group said long-term unemployment presents a dangerous challenge for the United States, since it risks becoming self-reinforcing and reducing the productivity of the labor force over time.

Just under half of the 13.7 million jobless Americans have been out of work for six months or longer, the highest ever.

The OECD noted that countries such as Germany and Japan, where firms were either reluctant to lay off workers or were able to reduce their hours through workshare arrangements, fared better than countries without such programs in place.

"The ability of these countries to cushion the employment impact of the crisis may offer lessons that could help improve labor market resilience to future shocks," the report said.

(Reporting by Pedro Nicolaci da Costa; Editing by Leslie Adler)