Fed's Bullard-years of near-zero rates can hurt growth

CHICAGO Feb 6 (Reuters) - Holding interest rates near zero for many years is unlikely to bring U.S. economic output back to pre-recession levels and may instead undercut long-run growth prospects, a top Federal Reserve official said on Monday.

St. Louis Fed President James Bullard said that unemployment is likely to stay high and labor markets to improve only slowly, even if rates are kept low for many years.

That's because the U.S. economy is suffering not from an "output gap" that can be bridged if only borrowing costs are kept low enough for long enough, he said, but from a permanent shock to household wealth delivered by a sharp drop in housing prices.

"The large output gap view may be keeping us all prisoner - tethering our expectations for output, in effect, to the collapsed bubble in housing," Bullard said in remarks prepared for delivery in Chicago. "A near-zero rate policy stretching over may years can begin to distort fundamental decision-making in the economy in ways that may be destructive to longer-run economic growth."

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.

The Fed last month said it would likely hold interest rates at rock bottom levels until late 2014. Fed Chairman Ben Bernanke was cautious about recent improvement in the U.S. economy and left the door open to new bond purchases to boost growth.

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.

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."