Fed's Pianalto sees slow rebound; inflation in focus

By Steve Robrahn

LOUISVILLE, Ky (Reuters) - Extreme weakness in the U.S. economy is moderating but recovery will be slow and marked by lingering high unemployment, a top Federal Reserve policy-maker said on Thursday.

Sandra Pianalto, president of the Cleveland Federal Reserve Bank, said the Fed's priority will shift as credit markets recover from preventing "unwelcome disinflation" to making sure that higher inflation does not develop from expansionary monetary and fiscal policies.

"It's the job of the central bank to keep inflation under control," Pianalto said in answering questions after a speech at the INVESTKentucky Conference in Louisville, Kentucky.

Some of the U.S. central bank's special lending programs, which were created to support credit markets and the economy during the current recession, will sunset naturally, Pianalto said. But others will require action.

"As we see signs that a recovery is underway, it will be our job to remove the stimulus. ... We will have to use tools and come up with a plan on how we shrink our balance sheet back as circumstances become more normal."

She did not address the likely trajectory of interest rates. The policy-setting Federal Open Market Committee has set its benchmark federal funds rate in a range of zero to 0.25 percent since December. Markets expect no change in 2009.

Pianalto is not an FOMC voting member in 2009 but will vote in 2010, when pressure to raise rates is likely to intensify.

Pianalto said sales and production should "begin to recover, although gradually, during the second half of the year" on the back of stimulus from the Fed and the White House, and a stabilization in housing prices.

A return of confidence to the financial sector is also key, and credit conditions "have certainly improved since last fall," she said.

Separately, New York Fed President William Dudley said that conditions in capital markets have improved recently, and that the Fed's program to backstop consumer lending has been picking up steam since a slow start in March.

Still, "securitization markets are still significantly impaired," Dudley said at a summit in New York hosted by the financial industry group SIFMA.

NO BET ON A FAST RECOVERY

Speaking at Churchill Downs racetrack, home of the Kentucky Derby, Pianalto was not betting on a quick return to strong economic growth and aggressive hiring.

"We may be tempted to hope that the economy will take off at a full gallop, but that is not likely to happen because of some long-standing imbalances within our economy," she said.

"It could take a long time before the unemployment rate returns to levels we think of as normal, and we might even need to revisit our definition of normal."