The U.S. Federal Reserve must continue to prop up the economy for an extended period but can't do so indefinitely for fear of triggering an inflationary surge, Federal Reserve Chairman Ben Bernanke warned on Thursday.

The U.S. central bank has cut interest rates to near zero percent and pumped hundreds of billions of dollars into the financial system to counter the worst financial crisis since the Great Depression.

At a Fed conference, where he discussed the central bank's ballooning balance sheet, Bernanke made clear that policymakers were thinking how to terminate support as recovery sets in.

Accommodative policies will likely be warranted for an extended period, Bernanke told participants at the conference held in the Fed's headquarters.

At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road.

Bernanke sent a signal the Fed is gradually but steadily moving toward an exit from its supportive policies, even while evidence of the recovery has been mixed.

A report last week showing that U.S. employers shed more jobs than expected in September dented confidence in the recovery. But data released on Thursday showed gains in retail sales and a nine-month low in unemployment claims reinvigorated optimism.

TOO LOW FOR TOO LONG

The dollar inched up from 14-month lows against a basket of currencies after Bernanke's comments, while his Fed colleague, Kansas City Fed President Thomas Hoenig, also warned of the perils of leaving rates too low for too long.

I don't believe necessarily an indefinite period of very accommodative policy is in the long-run best interests of the country, he told an economic forum hosted by his bank in Oklahoma City.

If you leave it at zero for too long a period, then we will have other issues, said Hoenig, who is seen as one of the more hawkish, or anti-inflation members of the Fed's policy-setting committee, where he will be a voter next year.

The dollar has been under pressure as the U.S. economy has lagged some other economies in recovering from a crisis that reverberated around the world.

On Tuesday, Australia became the first of the Group of 20 big industrialized and developing economies to increase borrowing costs, saying that the worst danger for the economy had passed.

Hoenig, asked by the audience about the Australian central bank's decision, said this reflected the better performance of the country's economy.

In the United States, most analysts do not see the Fed raising rates until the middle of next year.

And the European Central Bank on Thursday cautioned against hopes of a speedy economic recovery in the 16-nation euro zone as it left benchmark interest rates at a record low 1.0 percent on Thursday for the fifth month in a row.

ECB President Jean-Claude Trichet also turned up the heat on governments to rein in ballooning budget deficits, and said he saw hopeful signs of a normalization in money markets given lower demand for central bank loans.

FED PREPARED TO TIGHTEN

Although Bernanke indicated that it is not yet the time to roll back the Fed's supportive policies, he said the bank has the tools and the ability to pull back its flood of cash and loans to the economy and to raise interest rates when the time is right

When the economic outlook has improved sufficiently, we will be prepared to tighten the stance of monetary policy and eventually return our balance sheet to a more normal configuration, he said.

Bernanke gave a detailed tour of the Fed's assets and liabilities, which have ballooned from around to almost $2.1 trillion from $900 billion.

As the United States appears to be pulling out of a painful and lengthy recession, observers are watching closely for signs of when and how quickly the Fed intends to pull back its help.

Bernanke said the Fed could remove its easy money policies even while its balance sheet remains bloated.

To do so, it would raise interest rates on reserve balances that banks keep at the Fed and by other actions -- specifically reverse repurchase agreements, term deposits to banks, and sales of holdings of longer-term assets. Those steps would drain cash and help raise short-term interest rates, he said.

OPTIMISTIC BUT TOO SOON TO MOVE

Other Fed officials on Thursday sounded cautiously optimistic notes on the economy while saying it is too soon to pull back the life support system.

We're going to look at the data as it comes in. Right now I don't think it's time to raise interest rates, Richmond Fed President Jeffrey Lacker told reporters after a speech.

Another regional president of the U.S. central bank system, Richard Fisher of the Dallas Fed, echoed Lacker's comments.

We're going to move when we have to move. But it's not now, Fisher said in an interview with The Wall Street Journal.

Speaking in Phoenix, Fed Governor Daniel Tarullo also backed the idea of keeping interest rates low for some time, if only because the economy's prospects are so unsettled.

With the effects of the February stimulus package diminishing next year, bank lending that is still declining, and continued dysfunction in some parts of capital markets, there is considerable uncertainty as to how robust growth will be in 2010, he said at a community leaders lunch.

While the Fed has been under fire from Congress and other critics who believe its lenient oversight of financial institutions and lending practices contributed to the crisis, Bernanke got a significant political boost on Thursday when a key senator said he saw nothing in the way of his confirmation for a second term as Fed chairman.

Senate Banking Committee Chairman Christopher Dodd, asked if he saw any roadblocks to the Senate reconfirming Bernanke, whose four-year term expires in January, said, No, I don't think so.

I've indicated I want to be supportive. I think Ben Bernanke's done a very good job, particularly in the last year or so. I think that view is embraced by a lot of people, Dodd, a Democrat, told Reuters Television.

(Editing by Jan Dahinten)

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