WRAPUP 1-It's not time to raise rates yet, Fed officials say

LEXINGTON, Va., April 1 Thu Apr 1, 2010 7:16pm EDT

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LEXINGTON, Va., April 1 (Reuters) - U.S. interest rates are set to stay near zero for the time being, though the U.S. Federal Reserve stands ready to take action if signs of inflation begin to mount, top central bank officials said on Thursday.

William Dudley, head of the New York Federal Reserve Bank, offered a relatively measured outlook for the economy, arguing that while a sustainable U.S. economic recovery appears to be under way, growth is likely to remain subdued.

"Given the headwinds created by the collapse of the U.S. real estate market and its consequent damage to the financial system and household balance sheets, it seems unlikely that the recovery will be as strong as we would desire," he told students and faculty at Washington and Lee University in Lexington, Virginia.

Such weakness, reflected in the nation's elevated 9.7 percent unemployment rate, does not mean the Fed is not keeping a close eye on the possibility that inflation will rise.

St. Louis Fed President James Bullard said the U.S. central bank would need to act quickly if markets began to expect sharply higher levels of inflation.

"You've got an extraordinary policy in place because of the large shock we've suffered," he told reporters. "It's possible that inflation expectations could start to move out of control, and I think if that (were to) happen, that would trump everything and the Fed would have to come in and take action."

Bullard, a voting member this year on the Fed's policy-setting panel, stressed he does not think inflation expectations are currently out of control or even likely to become so in the future.

Dudley, a former partner at Goldman Sachs, agreed, describing long-term price expectations as "well anchored."

The Fed held rates steady near zero at its March meeting and renewed a pledge to hold borrowing costs exceptionally low for an extended period to nurse the struggling economy back to health.

Officials cite a high unemployment rate as justifying the extended period pledge, but Bullard's remarks show other pressures could force the Fed to tighten financial conditions.

Bullard said he expects a report on Friday to show that employers added jobs in March, in line with private forecasters.

"In general terms, the recovery is proceeding apace and labor markets will follow behind and will continue to improve, but we'd all like to see a positive number and we'd like to build on that going forward," he said.

However, he said that it would not be a sequence of positive jobs growth numbers alone that would prompt the Fed to drop its low-rate extended-period pledge. The U.S. central bank's next rate-setting meeting is at the end of the month.

"It depends on how the economy is looking going forward and we don't want to get ourselves in a box that we're going to take a particular action on a particular calendar date," he said.

Dudley expressed much the same view. Asked by reporters if a rise in mortgage rates following the end of the Fed's loan purchase program would prompt the central bank to consider reentering the market, he was noncommittal.

The Fed evaluates all of its facilities based on evolving economic conditions, he said, adding that the current state of affairs action did not seem warranted.

Also, just because the Federal Reserve is working on ways to remove monetary stimulus does not mean it is about to raise interest rates, Dudley said.

"Developing these tools is very different from when we're actually going to tighten monetary policy," he said.

Housing data was quite weak in February, sparking fears of a double-dip in the beleaguered sector. Other data, however, are pointing to strong industrial activity.

The Institute for Supply Management's manufacturing index for March jumped to 59.6 from 57.0, well above economists' forecasts. (Reporting by Pedro Nicolaci da Costa; Editing by Gary Hill)

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