By Ann Saphir
BIG SKY, Montana (Reuters) - Lawmakers should change the tax code to discourage household and business borrowing that threatens the stability of the financial system, a top Federal Reserve official said on Monday.
"You are all very aware that our country has gone through a difficult financial crisis and that we are still only beginning to make our way back from its impact," Minneapolis Fed President Narayana Kocherlakota told the Tri-State Bankers Summit in Big Sky, Montana.
The current tax code allows households to deduct interest payments on home mortgages and corporations to deduct interest payments on debt.
Policymakers could make new crises less likely to occur if they limit such deductions, which subsidize the kind of excessive borrowing that helped trigger the recent financial crisis, Kocherlakota said.
Less than a week after the Fed's policy-setting committee voted unanimously to keep rates near zero to support a recovery that has recently faltered, Kocherlakota gave few hints on his outlook for monetary policy.
A voter this year on the Fed's policy-setting panel, the head of the Fed's smallest regional bank earlier made the case for the central bank to raise interest rates this year.
On Monday he repeated his preference for core inflation, which strips out volatile food and fuel prices, as a guidepost for policy decisions and suggested he is still concerned over a recent rise.
"Core inflation is something I keep a close eye on, because that's going to tell me, regardless of the rate of unemployment," what the outlook for inflation is, Kocherlakota said. "We are seeing some upward pressure on that, in core inflation."
The core personal consumption expenditures price index -- excluding food and energy -- rose 1.2 percent in the 12 months through May, the biggest increase since August, a report showed earlier on Monday.
While still well below the Fed's informal 2 percent target, it is higher than it was when the Fed began its latest round of bond-buying stimulus last November. That suggests, Kocherlakota has said, that rates should be higher, a point he did not repeat on Monday.
High leverage leaves households and businesses vulnerable to shocks, Kocherlakota said. The housing market, whose collapse set off the 2007-2009 financial crisis, remains in a slump, with March home prices at lows not seen since March 2003, years before the housing market peaked.
But a drop in land prices may not have led to the crisis had households and business not been weighed down with so much debt, Kocherlakota said.
"The mortgage interest tax deduction undercuts financial stability," he said. "The tax code includes what is known as a corporate debt tax shield that encourages higher leverage for financial institutions."
Policymakers could still use tax incentives to promote home ownership, but instead of mortgage interest payment deductions, they could use tax credits on down payments, Kocherlakota said. Such a policy would help homebuyers without subsidizing their mortgage debt.
Likewise, policymakers could cut the corporate tax rate to encourage business investment, he said.
Last year's Wall Street overhaul legislation gave the Fed new supervisory powers over large banks that are meant to allow it to spot and defuse any build-up of risk in the financial system.
Policymakers should use tax policy to support those efforts, said Kocherlakota, a former University of Minnesota economics professor who spent much of his academic career researching tax policy.
Still, it is unusual for a top Fed official to give lawmakers such direct policy advice, especially since the central bank jealously guards its independence and is wary of appearing to step on the turf of others.
Kocherlakota did not address monetary policy in his prepared remarks.
(Editing by Dan Grebler)