Fed should raise rates in 2013, Bullard says

President and CEO of the Federal Reserve Bank of St. Louis James Bullard gestures during an interview at the Federal Reserve Bank of St. Louis in this June 8, 2011 file photo.

CHICAGO (Reuters) - The Federal Reserve should start raising interest rates next year, a top Fed official said on Monday, arguing that many years of near-zero rates will do little to return economic output to pre-recession levels and risks causing "disaster."

St. Louis Fed President James Bullard said he disagreed with the Fed's decision last month to keep interest rates exceptionally low through late 2014 to bolster a recovery that was moving too slowly.

Bullard, who does not have a vote on the Fed's policy-setting Federal Open Market Committee this year, is seen as a policy centrist.

"It's important to start to remove accommodation - even when you go up to 1 percent or 1-1/2 percent, that's still very easy monetary policy," Bullard told reporters. "It's a matter of getting to a normal level of interest rates at the right time. I don't think you want to wait until everything is exactly the way you'd expect it to be."

Fed Chairman Ben Bernanke last month gave a bleak assessment of the economy and left the door open to new bond purchases to boost growth, a move that Bullard said he would support only if the economy worsened further and the threat of deflation re-emerged.

The Fed cut rates to near zero more than three years ago and has bought $2.3 trillion worth of bonds to spur economic activity.

Because the recession was brought on by a collapse in housing that destroyed household wealth, unemployment is likely to stay high and labor markets will improve only slowly even if rates are kept low for years, Bullard said.

The belief that the U.S. economy suffering from an "output gap" that can be bridged only if borrowing costs are kept low enough for long enough is wrong, he said.

"If we continue using this interpretation of events, it may be very difficult for the U.S. to ever move off of the zero lower bound on nominal interest rates," Bullard said. "This could be a looming disaster for the United States."

The U.S. economy is on track to grow at a 3 percent rate this year and to strengthen further next year, Bullard said. That should help push the unemployment rate below 8 percent by the end of this year, he projected.

It registered 8.3 percent in January, and most Fed officials last month saw the rate staying above 8 percent through this year.

Meanwhile, inflation, while falling, is running above the Fed's newly set target of 2 percent.

Bullard said keeping rates low for several quarters is very different from keeping them there for years, which punishes savers. Younger generations hurt by high unemployment are not increasing their consumption to make up for the decline in consumption among older generations, he said.

"In this sense, the policy could be counterproductive," he said.

Some lawmakers in Congress levied a similar criticism against Bernanke last week, saying the Fed's low-rate policy was hurting savers and, in Congressman Paul Ryan's words, "bailing out" debtors.

Charles Schwab Corp's eponymous founder, in an op-ed in the Wall Street Journal on Monday, took the argument further, saying rock-bottom interest rates are destroying confidence in the economy and are unwisely forcing older savers to take risks with their money in search of decent investment returns.

In testimony last week, Bernanke said the Fed was "quite aware" of the costs of low-rate policy for savers, but he has repeatedly made the case that fostering faster growth overall is more important for the economy as a whole.

Bullard said he welcomed the Fed's adoption of an explicit inflation target because it may keep the central bank from allowing higher inflation in pursuit of bridging an illusionary output gap.

"This is an important development, as it may prevent the U.S. from repeating the mistakes of the 1970s, in which a misreading of the size of the output gap led the Fed to maintain easy monetary policies for far too long," he said.

(Editing by James Dalgleish)