Fed's Plosser: don't rule out curtailing bond buys

BIRMINGHAM, Alabama (Reuters) - A sustainable U.S. recovery is under way and the Federal Reserve may have to cut short its $600 billion bond buying plan if the economy continues to gather steam, a top Fed official said on Wednesday.

Charles Plosser, the head of the Philadelphia Federal Reserve Bank, said he takes seriously the U.S. central bank's pledge to regularly review the size of its second round of quantitative easing, known as "QE2".

"Should economic prospects continue to strengthen, I would not rule out changing the policy stance to bring QE2 to an early close," Plosser, who is one of the more hawkish Fed officials on inflation, told the Rotary Club of Birmingham, Alabama.

Plosser said he did not expect the uprisings in the Middle East to trip up the U.S. recovery. He said oil prices would have to rise significantly more, and stay higher for a while, to have a dramatic impact on the U.S. economy.

"I think the turmoil in the Middle East is less likely to be a problem for our economy than the challenges in Europe, the sovereign debt crisis there," he said in response to an audience question after giving a speech.

"It is going to be in their interest to keep the oil flowing."

Last year, the sovereign debt crisis in Europe was cited as a reason for the slowdown in the U.S. recovery.

CREDIBILITY

Plosser said if employment and output growth rates speed up or inflation expectations rise in the coming months, it could signal it is time for the Fed to take its "foot off the accelerator and begin to change course."

"We could change some things without replacing the current easy monetary policy with a tight policy. There's a big gap there," he told reporters.

Minutes of the Fed's January 25-26 policy-setting meeting showed some policymakers thought it unlikely the recovery would strengthen so significantly that it would warrant curbing the bond buying plan.

Fed Chairman Ben Bernanke will testify next week before a Republican-led Congress that has been skeptical of the Fed's continued monetary easing policy.

Plosser said he voted in favor of the Fed's policy statement at its meeting in January, which left the size of the purchase program intact, out of concern for the bank's credibility.

"I supported the continuation of the policy in January because it is generally a good practice for a central bank to do what it says it is going to do unless circumstances significantly change," he said. "To do otherwise would undermine the institution's credibility."

The Fed decided in November to launch a second round of bond buying to support a fragile economic recovery. Plosser rotated into a voting seat on the Federal Open Market Committee in January.

Plosser said he expects U.S. annual economic growth to be about 3.5 percent over the next two years and said it appears fears of deflation -- a sustained fall in prices -- have "largely abated".

Broader inflation should rise toward 2 percent -- the Fed's informal target -- over the course of 2011, he added.

"We are beginning to see some increasing price pressures," he said. The January consumer price index last week showed a pick-up in both headline and core CPI inflation. Core CPI rose just under 1 percent over the past year.

"My sense is that as the recovery continues to pick up steam and firms become more convinced that demand increases will be sustained, they will feel more confident they can put through price increases," he said.

But he played down the concern that rising commodity prices could have a direct impact on broader inflation.

"It is likely that much of the rise in global commodity prices is driven by increased global demand," he said.

Plosser expects the unemployment rate -- currently at 9 percent -- to decline only gradually, falling to between 7 and 8 percent by the end of 2012.

But he reiterated that he views it as "dangerous" to rely on monetary policy to solve the necessary but difficult and time-intensive labor market adjustments.

"The shocks and dislocations we experienced from the financial crisis were significant, and it will take time for the labor markets to adjust," he said.

Plosser expects high inventory levels to restrain home prices and residential construction "a while longer" and business spending to continue at a healthy pace.

(Reporting by Kristina Cooke; Editing by James Dalgleish)