UPDATE 2-Fed's Stern says U.S. slowdown could be lengthy

(Adds comments from Q&A)

By Ros Krasny

THREE FORKS, Montana, Aug 14 (Reuters) - Minneapolis Federal Reserve Bank President Gary Stern said on Thursday the United States could see modest economic growth and rising joblessness for some time, while inflation should ease.

Stern, the Fed's current longest-serving district president, also offered a framework for reform of financial institutions to hold back the ever-expanding safety net for large firms.

A few weeks ago Stern was among a number of Fed speakers who seemed anxious for the central bank to start raising interest rates to head off an inflation threat.

On Thursday, though, Stern, a voting member of the policy-setting Federal Open Market Committee in 2008, seemed more at ease with the outlook for prices, and also wary that the U.S. slowdown could be prolonged.

Stern did not specifically address the interest rate outlook, but said that "a diminution of inflation, absent a resurgence in energy and other commodity prices" is likely.

Speaking to local business leaders in Three Forks, Montana, Stern said the economic slowdown in the early 1990s "remains a valuable guide," with a pattern suggesting it could be one to three years before the United States returns to robust growth.

"I'm not predicting that, but I can't rule it out," Stern said in answer to questions from the audience.

Stern's comments were seen as consistent with the view in financial markets that the FOMC will hold benchmark lending rates steady at 2 percent at least through year-end.

"Clearly, these are not the words of a man intent on hiking interest rates anytime soon," said Michael Feroli, U.S. economist at JP Morgan Economics.

Stern said the U.S. economy was in better shape on several measures when it entered the current slowdown than it was in the early 1990s.

Credit markets will "inevitably" pick up, but for now "a variety of potential borrowers are finding funding more difficult and expensive to obtain," he said.

Meanwhile, the downturn in the housing market continues and the run-up in energy and other commodity prices "has taken a toll on consumer discretionary spending," he added.

Earlier on Thursday, the government reported that U.S. consumer prices in the 12 months to July jumped at the fastest pace in 17 years, led by rises in the cost of energy and food.

Oil prices, however, have begun to decline recently, and fell further on Thursday. Prices across a range of commodities have also tumbled over the past month.

Stern said the Fed looks at both headline and core inflation, because each has a comparative advantage in answering different questions about the economy.

Core measures, which exclude often volatile food and energy prices, give "a better picture of underlying inflation," while headline figures give a better read on the issues facing consumer spending, he said.

TAKING ON "TOO BIG TO FAIL"

Stern devoted much of his remarks to outlining potential regulatory steps in the wake of a year's worth of actions by the Fed, the Treasury and other agencies to cope with the global credit and banking crisis.

Stern, the Fed's 9th District president, has long been a critic of the ever-expanding safety net for large financial firms.

Actions taken over the past year were "appropriate" but also point out the need for enhanced supervision to "reduce the likelihood of full protection of uninsured creditors of large, complex financial institutions," he said.

Stern outlined an approach that he termed "systemic-focused supervision," centered on stress testing, enhanced and prompt corrective action, and communication.

"These efforts offer important actions in a long-term effort to limit the spillovers from the failure or impairment of a systemically important financial institution," he said.

Stern said that as part of a prompt correction action regime, banks whose capital falls below a given level might have their ability to pay dividends constrained, and chartering authorities could shut banks whose capital falls below an even lower trigger.

"Closing banks while they still have positive capital, or at least a small loss, can reduce spillovers in a fairly direct way," he said. (Additional reporting by Tamawa Kadoya in New York; Editing by Leslie Adler)