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WASHINGTON (MarketWatch) - Although it appears too good to be true, the U.S. economy appears on the verge of achieving a fabled "soft landing" of moderate growth and gradually lower inflation, said Federal Reserve Vice-Chairman Donald Kohn on Wednesday.

"I expect that the continuing adjustment will be relatively benign overall," Kohn said in remarks prepared a business group in New York. Read full text of Kohn's speech.

"The economy will grow at a moderate pace for a while, somewhat below the rate of increase of its potential, and then growth will begin to strengthen," Kohn said.

In addition, "I think we will likely see much lower headline inflation and a gradual diminution of core consumer price inflation," he said.

But there are heightened risks on both sides of his forecast, Kohn said. He said the risks to his outlook for growth are tilted a bit to the downside, and the risks to his inflation outlook are tilted to the upside.

He expressed surprise that financial markets don't seem to share his sense of uncertainty about the proper level of short-term interest rates.

Financial markets, as viewed by the Fed funds futures market, are making a one-way bet. They believe the Fed is finished tightening in this cycle and have priced in a rate cut some time in the first quarter.

"Obviously, as my FOMC voting record indicates, I believe that for now, the current level of short-term interest rates has the best chance of fostering this outcome [of a soft landing], " Kohn said.

But policy adjustment will depend on the implications of incoming data to his forecast, he said.

After 17 straight meetings with a rate hike, the FOMC called a halt in August and September. But there was one dissent at each meeting in favor of higher rates.

Kohn said that the upside risk of inflation is the dominant concern at the moment.

"Although to date inflation expectations have remained contained, failure to check and then reverse the greater inflation pressures of earlier this year would risk embedding those higher inflation rates in the decisions of households and businesses, an outcome that would be costly to reverse and would impinge on the economy's long-term performance," he said.

But Kohn did not seem to buy into the inflation fears expressed by some Wall Street economists.

Kohn said he did not think recent unit labor costs were a cause for concern.

"In my own thinking, I have tended to discount, though not dismiss, the latest readings on labor costs," he said. Some gains in costs appear to be the result of stock options, he said.

Kohn also said that shelter costs, which have driven up the core consumer inflation this year, are not a big concern for him.

"I think the odds favor a gradual reduction in core inflation over the next year or so," Kohn said.

Kohn said the economy should continue to grow despite the weakness in the housing sector.

The preconditions of a recession "do not seem to be in place," he said.

In the past, recessions have been triggered by highly restrictive monetary policy and tight credit conditions through high long-term rates, he said.

"Obviously these conditions are not present today," he said.

Instead, financial conditions remain quite supportive of borrowing and spending, Kohn said.

Based on the data in hand, Kohn said that growth of real GDP in the third quarter will be "as subdued" as the 2.6% growth rate in the second quarter, "and may well have slowed further."

He said there is little evidence to expect "any sharp shift" in the fourth quarter.

"If that is so, the economy could be in the process of registering several consecutive quarters of growth below its potential rate, the first time it has done so since early 2003," Kohn said.

Once the "inventory overhang" in residential housing and autos are worked off, economic growth "should pick up again "to a rate close to its potential rate, Kohn said. This rate is currently estimated by the Congressional Budget Office at a 3.25% GDP annual rate.

Kohn said he did not know exactly when the housing market would hit bottom. But, just as Fed chief Ben Bernanke earlier on Wednesday, Kohn was generally optimistic about the outlook for the housing market, saying that fundamentals and low interest rates should put a floor under the market. See full story.

"To date, there is little evidence that this correction in the housing market has had any significant adverse spillover effects on other parts of the economy," he said.