Fed's Schmid says it is uncertain how far interest rates can fall

By Howard Schneider

WASHINGTON (Reuters) - It remains uncertain how far interest rates can fall, though the initial reductions made by the U.S. central bank are a vote of confidence that inflation is returning to its 2% target, Kansas City Fed President Jeffrey Schmid said on Tuesday.

"The decision to lower rates is an acknowledgement of the ... growing confidence that inflation is on a path to reach the Fed's 2% objective - a confidence based in part on signs that both labor and product markets have come into better balance in recent months," Schmid said in remarks prepared for delivery to the Omaha Chamber of Commerce.

He said that while progress back to the 2% target meant it was a proper time to cut rates, it still "remains to be seen how much further interest rates will decline or where they might eventually settle."

Schmid, who will have a vote on the Fed's interest rate policy next year, did not comment on whether he would favor a quarter-percentage-point rate cut at the central bank's Dec. 17-18 meeting.

The bulk of his prepared remarks focused on issues like demographics and productivity that could influence monetary policy over the long run by changing the underlying dynamics of inflation.

But on the more current issue of federal government spending, Schmid said "large fiscal deficits will not be inflationary because the Fed will do its job" to keep inflation at the established 2% target.

That, however, could mean "persistently higher interest rates," Schmid said, a reason why it was important for the Fed to remain independent in setting monetary policy.

"Political authorities could very well prefer that deficits not lead to higher interest rates, but history has shown that following through on this impulse has often resulted in higher inflation," he said.

(Reporting by Howard Schneider; Editing by Paul Simao)