Low yields are warning Fed to think twice on rate hike - Kaplan

By Jonathan Spicer

LUBBOCK, Texas (Reuters) - Financial markets are warning of weakness in the U.S. economy, so the Federal Reserve should be "very patient and judicious" as it considers whether to raise interest rates, a policymaker in the Fed's cautious camp said on Thursday.

In a speech and press conference, Dallas Fed President Robert Kaplan underscored his concerns about a series of weak inflation readings, saying he wants to see evidence that it would rebound "in the medium term" before he could support another rate hike.

Minutes from the U.S. central bank's July meeting showed division between those officials who believe the price weakness is temporary and should not derail tightening plans, and those like Kaplan who have taken pause.

"There is no doubt that as the (yield) curve gets flatter and inverted, that is a sign of economic trouble," Kaplan, a voting member of the Fed's policy committee this year, said of the 10-year Treasury yield at 2.2 percent. "I'm sensitive to that fact ... and I think we need to be very patient and judicious in the next moves on the fed funds rate. That's what it tells me."

Some investors see bond yields as unusually low given the Fed has raised rates three times since December. It could signal expectations of an economic downturn, or could simply reflect better than expected growth in Europe and elsewhere.

U.S. stocks, which are sensitive to comments from Fed officials on financial markets, pared some of the day's hefty losses after Kaplan spoke. While Fed forecasts see one more rate hike by year end, investors give that about a 40 percent chance.

"We have to be careful in our further moves" on policy, Kaplan added at a Lubbock Chamber of Commerce luncheon.

On Wednesday, Kaplan's counterpart at the Cleveland Fed offered the counterpoint in the internal central bank debate.

"I expect the long bond rate to go up as we continue on this strategy of gradually removing accommodation," Loretta Mester told Reuters in an interview in New York. "I don't think that the long bond rate being low is a signal that we are going into recession."

The Fed's preferred inflation measure is 1.5 percent, below a 2-percent target.

Kaplan, speaking to reporters, said: "I don't need to see that we're going to meet that target in the near-term. I just want to see evidence, or belief, that we're going to meet that target in the medium term."

(Reporting by Jonathan Spicer; Editing by Chizu Nomiyama)