Fed's Warsh says market recovery will take time

NEW YORK (Reuters) - The U.S. Federal Reserve is prepared to play a role in repairing fractured financial markets, but recovery will take time and be uneven, Fed Governor Kevin Warsh said on Monday.

"While the adjustment process by financial intermediaries is showing signs of promise, the healing process is not likely to be linear," Warsh told the New York University School of Law. "Given the fragility evidenced in financial markets and the toll it is taking on real activity, the Federal Reserve agreed to take center stage."

The Fed's interest rate cuts and liquidity steps to date have been aimed at limiting further damage to the economy from the credit crisis, he said. While the economy faces downside risks, the U.S. central bank is also concerned about inflation and is monitoring prices closely, Wash said.

"Increases in food and energy prices have pushed up overall consumer prices and are putting upward pressure on core inflation and inflation expectations," he said.

The central bank has slashed interest rates by three percentage points since mid-September and provided hundreds of billions of dollars in liquidity to keep bank credit flowing. It is expected to reduce rates again when its policy committee meets on April 29-30.

But even as the Fed has raced to restore smooth market functioning and thaw frozen credit markets, oil and other commodity prices have pushed consumer prices higher, leading to a worrisome rise in inflation in recent months.

With evidence that markets are beginning to build persistenty higher rates of inflation into forecasts, the Fed is limited in how much more it can lower interest rates, or how long it can keep interest rates low, without fueling inflationary pressures.

Warsh said that when credit markets regain some stability, the rate cuts should gain more traction and provide greater support for the economy.

Asked if the Fed's string of interest rate cuts had any perceptible impact on preventing an economic slump, Warsh said conditions would be worse absent the central bank's action.

Still, it would take time for the full impact of the rate cuts to be felt, he said. "Our tools are incredibly powerful but they don't work overnight."

Warsh said liquidity measures unveiled by the Fed had eased market strains somewhat. At the same time, markets will not fully recover until private institutions step up and begin lending to one another again.

"Only when ... significant private financial actors return to their proper role at center stage will credit market functioning and support for economic growth be fully restored," he said.

In the meantime, he said further shocks were likely ahead as financial institutions report and write down assets that have lost value.

"Contemporaneous changes in balance sheets and income statements by incumbent financial institutions -- most notably, deleveraging and paring of business lines -- are likely to prove highly consequential to the near-term outlook for the real economy," Warsh said.

He declined to comment explicitly on the dollar's decline, but did say that central bankers could not be completely indifferent to the value of their currency.

He touted the need for increased transparency, saying that was up to not only regulators but investors themselves. If anything, he said, the crisis was forcing lenders to require greater clarity of potential borrowers.

(Reporting by Pedro Nicolaci da Costa and Burton Frierson in New York and Mark Felsenthal in Washington)