CORRECTED - UPDATE 1-Fed's Fisher - bad fiscal policy pressures the Fed

(Corrects quote in seventh paragraph to say "debased" instead of "rebased") (Updates with more Fisher comment, background)

DALLAS, April 16 (Reuters) - Dallas Federal Reserve Bank President Richard Fisher said on Monday the United States faces grave fiscal challenges and unless these are resolved, it will have implications for Fed policy and the dollar.

"Congress holds the power of the purse. But the Fed cannot be an indifferent bystander to the overall thrust of fiscal policy," he said in remarks to the Equipment Leasing and Finance Association.

Fisher is not a voting member of the U.S. central bank's policy-setting committee this year.

"Bad fiscal policy creates pressures for bad monetary policy. When fiscal policy gets out of whack, monetary authorities face pressure to monetize the debt, a cardinal sin in my mind," Fisher said.

This combination would be very problematic for the U.S. economy, since it could undermine confidence in the dollar.

"The dollar ... is what economists call a fiat currency. It is backed only by the federal government's power to raise the revenues needed to meet its obligations and by the rectitude of the U.S. central bank.

"If the markets were to lose faith in either assumption, the dollar would be debased," Fisher cautioned.

He said that plans to limit the current U.S. budget deficit would require difficult choices between taxes and spending, but the real problem lies ahead in reforming entitlement spending like Social Security and Medicare.

"Our short-term fiscal challenges are significant as we grope our way toward a future in which we begin to pay down the federal debt. The long-term challenge of entitlements is much more severe," Fisher said.