Fed's Kohn: signs economy may stabilize in 2009

NEWARK, Delaware (Reuters) - The deep U.S. economic recession may be letting up and a modest recovery could set in later this year, the Federal Reserve's number-two official said on Monday.

Recent developments "may be an early indication that conditions are falling into place for real GDP to decline at a slower rate in the second quarter and to stabilize later this year," Fed Vice Chairman Donald Kohn said in a speech at the University of Delaware.

Recovery may be gradual, however, Kohn said, and added that the Fed would not hesitate to deploy new weapons to boost growth if the anticipated rebound is weaker than expected.

"The risk that inflation could be lower will be exacerbated to the extent that economic activity falls short of the path that I have described," he said. "In these circumstances, the Federal Reserve would continue to look for ways to relieve financial pressures and encourage spending."

The U.S. central bank's policy-setting panel meets next week. At its previous meeting in March, the Fed renewed its pledge to keep interest rates very low for an extended period. It also committed to push an additional $1.15 trillion into the economy by buying longer-term Treasury securities and buying more debt and mortgage-backed securities issued by mortgage finance agencies.

Kohn said on Monday the current recession looks likely to be among the deepest and longest of the post-World War Two era. Economic growth in the first quarter is expected to show a "sizable decrease," he said, and data on claims for unemployment insurance point to continued substantial job losses.

But consumer spending has steadied in the first three months of the year and declines in home sales and construction seem to have abated, he said.

"I don't think it is premature to start to ponder the shape that a recovery -- when it occurs -- would be likely to take," he said.

Kohn said financial markets battered by the credit crisis that followed the collapse of the U.S. housing sector remain disrupted and fragile.

The saving rate may stay high for a while as fallen home values and shrunken household wealth restrain spending, he said.

"Shoring up personal financial positions may trump a rebound in spending for a time -- especially if unemployment continues to rise," he said.

There are risks on both sides of the inflation equation, Kohn said. The Fed is "acutely aware" that the massive amounts of money it has pumped into the economy harbor a risk of fueling uncomfortably high inflation when the recovery takes off, he said.

"We are firmly committed to acting in a way that preserves price stability, and we believe we have the tools to absorb reserves and raise interest rates when needed," he said.

The Fed is bracing for political pressure not to raise borrowing costs when the central bank's policy-makers deem it necessary, Kohn added.

"I am sure that when we get ready to raise interest rates there will be a lot of criticism. There always has been," he said in response to a question.

But he later said in response to questions that he believed an unwelcome drop in prices is currently a greater worry.

(Reporting by Mark Felsenthal, Editing by Chizu Nomiyama)