By Kristina Cooke
ROCHESTER, New York (Reuters) - The U.S. Federal Reserve must be prepared to raise interest rates if needed before the jobless rate has fallen to an "acceptable level", or risk losing its inflation-fighting credibility, a senior Fed official said on Tuesday.
Philadelphia Federal Reserve Bank President Charles Plosser said he has become more confident in the sustainability of the U.S. economic recovery even once government stimulus fades, and stressed the Fed must take a forward-looking approach.
Plosser, who will not have a vote on the Fed's policy-setting committee until 2011, said he expects the U.S. economy to grow at around three percent over the next two years.
"Looking ahead, I see an economy that will be growing over the next two years, which means real interest rates will be rising," he told an economic seminar in Rochester, New York.
"As they do, the federal funds rate should be permitted to rise with them" to ensure the Fed can promote stable inflation expectations and sustainable growth.
The Fed cut the federal funds rate -- the benchmark U.S. interest rate -- to near zero last December and has kept it there since.
The central bank's policy-makers, after their last meeting in November, repeated a pledge to keep rates exceptionally low for "an extended period", and most analysts do not expect the Fed to raise rates until the second half of 2010.
The Philadelphia Fed chief, who is known as an inflation "hawk", said "increases in interest rates may be appropriate before unemployment or other measures of resource slack have diminished to acceptable levels."
"Failure to act in this manner risks continuing to inject liquidity into a growing economy at a rate that will create inflation above desirable levels later in the cycle," he said.
"If this were to happen, the Fed would lose its credibility to preserve low and stable inflation," he said.
Plosser said the Fed's political independence was crucial as it will have to make potentially unpopular decisions about the timing of interest rate hikes. His comments followed a rare newspaper column by Fed chairman Ben Bernanke this weekend, in which he argued that congressional proposals to audit the Fed could damage future economic prospects.
"Will we get political heat? Probably," Plosser said. "But we always do... that is why our political independence is so important."
Even as he was generally upbeat about the economic outlook, Plosser sounded some notes of caution. The U.S. jobless rate is at a 26-1/2 year high of 10.2 percent and Plosser said he expects it to edge higher before beginning a gradual decline.
"The recovery of jobs from this very severe recession will take time. It is likely to take a couple of years before we see the unemployment rate back to more acceptable levels," Plosser said.
Plosser said he is not expecting strong consumer spending growth in the coming quarters and that it will take time before the Fed can be fully confident in the health of the financial sector.
His caution on the outlook for consumer spending were echoed by minutes of Fed board meetings on the discount rate, which the Fed charges on direct loans to banks. The minutes, released on Tuesday, showed directors at regional Fed banks favored keeping interest rates low in November because of the risk an economic pickup might falter on weakening consumer spending, the minutes showed.
Some of the regional Fed directors said they saw little chance that excess capacity in the economy was likely to shrink soon, which meant there was little likelihood of prices climbing sharply.
Plosser argued that while near-term prospects for both deflation and inflation may "seem mostly benign", the outlook for inflation is becoming more hazy.
"Unfortunately, the prospects for inflation over the next two to five years are much more uncertain in my view, and apparently in the view of the market as well," he said.
Plosser said that without timely and appropriate steps to withdraw or restrict the extraordinary amount of liquidity the Fed has provided to the economy, the inflation rate will likely rise to unacceptable levels.
"The great challenge facing the Fed is getting those 'appropriate steps' right," he said.
In addition to slashing interest rates sharply as the global financial crisis gathered pace last year, the Fed also instituted a number of emergency lending programs to keep the financial system afloat and promote economic recovery.
Plosser told reporters after his speech that no decision has been made on which tools the Fed will use and in what order, but that the central bank had a number of options.
The need for the Fed's extraordinary provision of liquidity will "continue to dissipate" in coming months, Plosser said.
(Reporting by Kristina Cooke, Editing by Chizu Nomiyama)