By Kristina Cooke
EASTON, Penn. (Reuters) - The Federal Reserve will have to act quickly, and "perhaps aggressively" when the time comes to pull back its extraordinary support for markets in order to avoid stoking inflation, the president of the Federal Reserve Bank of Philadelphia said on Tuesday.
"The Fed will need courage," Charles Plosser said in remarks prepared for delivery at Lafayette College in Easton, Pennsylvania. "I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels."
The Federal Reserve cut interest rates to near zero percent last December and put in place an unprecedented array of emergency support programs as it battled the deepest recession since the Great Depression. That has worried some market participants that inflation will result.
"Just as the Fed has taken aggressive steps in flooding the financial markets with liquidity during this crisis to reduce the possibility of a second Great Depression, it will also have to take the necessary steps to prevent a second Great Inflation," Plosser said.
"We recognize the costs that significantly higher inflation and the ensuing loss of credibility will impose on the economy if we fail to act promptly, and perhaps aggressively, when the time comes to do so," he said.
The Federal Reserve's policy-setting Federal Open Market Committee -- of which Plosser is not a voting member this year -- said at its September meeting that it would keep rates very low for a long time. Most economists expect the Fed to start raising rates next year. For more see <FED/R>.
Plosser said inflation will likely remain subdued in the near future, but he sees "a greater risk of higher inflation in the intermediate to long-term."
"First, monetary policy is extremely accommodative. Second, I put less weight than many other economists do on the idea that economic slack or low resource utilization is a reliable predictor of inflation," he said. Slack refers to the gap between potential output and current levels of production and employment.
A lesson from the high inflation of the 1970s, he said, was that if inflation expectations become unanchored, inflation can take hold regardless of the amount of economic slack.
Like most economists, Plosser said he expects the U.S. economy to return to growth in the second half of this year.
"Signs are finally indicating that the economy is turning a corner and prospects for a return to growth are increasing," Plosser said.
He said he expects growth to pick up to about 3 percent in 2010, and then to settle down to a long-term trend rate of about 2.7 percent in 2011.
The unemployment rate -- which climbed to 9.7 percent in August-- will "continue to creep up for a little while longer," he said.
"We will see the unemployment rate come down only well after the economy begins to recover," he said.
The outlook for consumer spending is a "mixed bag," he said, and reasons to remain cautious include job losses and homes that are worth much less than they were before the crisis hit.
The crisis has brought greater scrutiny to bear on the Fed, worrying some that its independence is at stake. Plosser said the central bank's freedom from political interests is critical to its ability to achieve its objectives of maximum employment and stable prices and moderate long-term interest rates.
"Research has shown that countries with more independent central banks have lower rates of inflation on average, without sacrificing real economic growth," Plosser said.