By Ros Krasny
NASHVILLE, Tenn (Reuters) - The Federal Reserve will not allow its unorthodox policies to lead to a surge in inflation as the U.S. economy recovers, Fed Vice Chairman Donald Kohn said on Saturday, though he said the U.S. central bank may need to do even more to ease credit if the economy fails to respond to stimulus measures.
"The key to preventing inflation will be reversing the programs, reducing reserves, and raising interest rates in a timely fashion," Kohn said in remarks prepared for a conference at Vanderbilt University in Nashville.
Kohn, the Fed's No. 2 policy-maker, emphasized the importance of inflation expectations in holding down future inflation.
"If expectations are not anchored -- if they vary in response to our actions or to persistent gaps between actual and potential output -- inflation itself will follow," he said.
On Friday, a survey-based forecast of one-year inflation expectations, from the University of Michigan, jumped surprisingly to 3 percent in April from 2 percent in March.
Kohn said the policy-setting Federal Open Market Committee is still mulling the value of setting an explicit objective for inflation -- a step further than it went earlier this year, in publishing "longer-run" inflation forecasts.
He did not discuss the economic outlook at length, but said the central bank's attempts to heal ailing credit markets have been working, in ways that include lowering mortgage interest rates. The U.S. economy is now in its sixth quarter of recession.
"The situation in financial markets and the economy would have been far worse if the Federal Reserve hadn't taken the actions we did," Kohn said.
He conceded that some Fed officials are uncomfortable with what could be seen as selectively allocating credit across various markets, but said the interventions have been carefully chosen.
"We choose them based on judgments that improved functioning will reduce systemic instability or have a material effect on credit flows and the economy and that our actions have high odds of yielding improvements," he said.
With the Fed's independence under threat from Congressional scrutiny, Kohn said the central bank would give Congress the additional information it seeks about its lending programs, and welcomed a review.
"The public is naturally interested in our lending practices, and we will be releasing even more information about what stands behind our loans in coming weeks," he said.
"However, increased attention to, and occasional criticism of, our activities should not lead to a fundamental change in our place within our democracy. And I believe it will not."
The FOMC has embarked on a process often known as quantitative easing since lowering its main monetary policy tool, the fed funds rate, to almost zero percent in December.
The central bank's balance sheet has been run up to some $2 trillion and is expected to go much higher.
"High levels of Federal Reserve assets and resulting reserves are likely to be essential to fostering recovery," Kohn said.
Rising reserves have followed market interventions rather than being a goal in themselves.
Kohn said the Fed has discussed whether making explicit objectives on the size of its balance sheet would help to better communicate the Fed's thinking.
(Editing by Leslie Adler)