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Fed's Evans: low inflation means interest rates should stay low

CORALVILLE, Iowa, Jan 15 (Reuters) - The low rate of U.S. inflation is "both puzzling and worrisome," a top Federal Reserve official said on Wednesday, and is reason enough to keep interest rates low for some time to come even if the labor market outlook continues to brighten.

In a nod to an improving jobless rate, which ticked down to 6.7 percent in December, the Fed this month reduced its massive bond-buying program to $75 billion a month from $85 billion a month and said it would probably phase the program out entirely late in the year.

Chicago Federal Reserve President Charles Evans warned that the current level of 6.7 percent unemployment is still well above the "normal" unemployment rate of 5.25 percent.

And, he said in remarks prepared for delivery to a business group for the greater Iowa City region, "This decision does not, however, mean we thought the economy needed less overall policy accommodation."

Instead, he said, the decision to reduce the bond-buying program was merely a shifting of the mix of policy tools, with the Fed relying less on so-called quantitative easing and more on forward guidance, telling markets what to expect in terms of Fed rate policy.

Specifically, the Fed said it would keep rates near zero until "well past the time" that unemployment falls to 6.5 percent, especially if inflation continues to linger below the Fed's 2-percent target. Inflation, by the Fed's preferred gauge, has risen just 1.1 percent in the past 12 months.

"This elaboration of our forward guidance should more strongly communicate that we are in no hurry to raise rates: We will not prematurely reduce accommodation in an economy with elevated unemployment and very low inflation pressures," he said Wednesday.

"Importantly, in my mind, the low readings for inflation by themselves now suggest that it likely will be appropriate to keep the funds rate at its current level for quite some time."

With growth expected to rise to just 2.75 percent this year, in his view, and unemployment to fall to 6 percent or "a bit lower" by the end of 2015, the Fed "must continue to be willing to use (its) tools to put us on a clear track back to full employment and inflation averaging our 2 percent target."

Low inflation, he said, is particularly troublesome, because without the lift of rising prices debt becomes more burdensome than expected and the economy slows. Even with the Fed's super-easy monetary policy, he forecast inflation to rise only slowly, approaching 1.5 percent by the end of next year.

"Very low inflation in an environment of rebounding growth and highly accommodative monetary policy continues to be both puzzling and worrisome," Evans said.