Fed's Bullard: need solid recovery before tightening

NEW YORK Nov 8 (Reuters) - The Federal Reserve could remove some of the extraordinary support it has extended to the U.S. economy once the recovery looks solid and monthly job growth has returned, a top U.S. central bank official told the Financial Times.

In an interview posted on the newspaper's website on Sunday, St. Louis Federal Reserve Bank President James Bullard said he would not favor tightening monetary policy before recovery was well-established.

"You are going to need to have jobs growth and you are going to need to have unemployment declining," said Bullard, who moves into a voting seat on the Fed's rate-setting panel next year.

A report on Friday showed the U.S. unemployment rate surged to 10.2 percent in October, leading traders in the interest rate futures market to cut bets on the central bank raising overnight interest rates by the middle of next year.

The Fed cut the benchmark the federal funds rate to near zero in December and put in place a vast array of emergency liquidity facilities in an effort to combat the worst financial crisis and recession since the 1930s.

As part of its emergency efforts, it has bought long-term government and mortgage-related debt to try to drive down borrowing costs.

The central bank has pledged to keep interest rates extraordinarily low for "an extended period". Most analysts expect it to hold rates near zero until mid-2010 or later.

Bullard said that tightening monetary policy "does not have to involve as its first step moving the federal funds rate off zero". Instead, he favored at that point selling back assets the Fed had acquired, the Financial Times said.

Many Fed officials have said asset sales could disrupt financial markets and push up long-term interest rates. But Bullard said that with proper planning, asset sales did not need to be disruptive.

The St. Louis Fed chief told the newspaper that uncertainty over the outlook for inflation was "as high as it has ever been since 1980".

He said that the United States still faced the lingering threat of deflation, but may have to pivot quickly once the danger of potential deflation passes to face the threat of excess inflation.

"I think there's still some risk of deflation, but I do think the deflation risk is fading as the economy recovers," Bullard said.

In the medium term, "you have inflation that will be possibly substantially above target over a horizon of two to four years, and that, I think, is because of the combination of very large fiscal deficits in the U.S. with very easy monetary policy," he added.

Bullard said that for 2009 and "maybe a little bit into 2010", the worry would be getting out of the recession and making sure the recovery had taken hold.

He said he expected growth of 3.5 percent to 4 percent next year. He thought unemployment would peak at a little over 10 percent and would decline by perhaps "a point and a half" by the end of 2010, the FT reported.

Bullard noted that the Fed has historically waited until two-and-a-half to three years after the end of a recession before raising interest rates.

But he said the U.S. central bank could take into account a wider set of factors this time, including the danger that ultra-low rates could fuel asset price bubbles.

"What is different this time is that the argument about staying too low for too long is going to weigh pretty heavily on the committee. It is more than just: 'What does the output gap look like; what does inflation look like?'"

Another issue, he said, was whether "you are generating the conditions that might foster a bubble that really might come back to hurt you later. I think this will be a big issue for the committee."

The Fed's balance sheet has more than doubled to $2 trillion during the crisis, due to the central bank's unconventional asset-purchase policies.

Bullard warned that living with a bloated balance sheet for too long would risk fueling inflation.

"I am concerned that if, over a longer term, you just leave this many reserves in the system, under any normal theory ... that is raw material for the money supply," he said. (Editing by Alex Richardson)