U.S. Federal Reserve policy-makers fanned out across Europe on Tuesday to express confidence that current policies can restore economic growth over time.

However, James Bullard, president of the St Louis Fed, warned that a deflationary trap is a real possibility this year for the struggling U.S. economy.

Meanwhile, at a hearing on Capitol Hill, Fed Chairman Ben Bernanke said September's rescue of insurance giant American International Group helped avoid the risk of an epic financial market collapse.

Investors' willingness to participate in many of the Fed's innovative programs, including the recently launched Term Asset-Backed Securities Lending Facility, is a good sign for the economy, said Charles Evans, the Chicago Fed president.

The Federal Open Market Committee's policy decisions have been calibrated to deal with the 'adverse feedback loop' between disruptions to financial market stability and the real economy, Evans said at a conference in Prague.

They will also have a stabilizing effect on markets around the world and will therefore eventually stimulate worldwide economic recovery.

Evans said TALF had already helped out the ABS market, while Bullard noted that the Fed's recent moves to buy mortgage-based securities have had an impact as well.

The Fed and other central banks have considerable scope to ease the global downturn despite extremely low interest rates, Bullard said in a speech to the Cass Business School.

Allowing the Fed's balance sheet to expand further with rates at near zero, through measures often labeled quantitative easing, can avoid a damaging rise in real, or inflation adjusted, interest rates, he added.

Evans is a voting member of the FOMC in 2009. Bullard does not have a vote this year.

INFLATION VS DEFLATION

Evans said inflation expectations are well maintained despite the mammoth amounts of funding pumped into U.S. credit markets by the central bank since the worst financial crisis in 70 years erupted in 2007.

The weak outlook for growth and the prospects for unusually low inflation call for more policy accommodation, Evans said. There are disinflationary forces at work.

Kansas City Fed President Thomas Hoenig, in an interview with Dow Jones Newswires, played down the risk of deflation.

The odds of deflation are fairly remote, I've always thought that, he said.

But Bullard, who termed deflation a real possibility for the United States, advocated specific inflation targets for the Fed to help control the risks of both a Japan-style deflation in the short term and of high inflation further down the track.

A credible plan would also name an explicit inflation objective to help control the very diffuse expectations of medium-term inflation, he said.

The FOMC moved further along the path to explicit inflation targets by issuing new long-run outlooks along with the minutes of its January 27-28 policy meeting.

Despite optimism about the steps the Fed has taken, Evans said the U.S. jobless rate, which hit a 25-year high of 8.1 percent in February, could peak above 8.5 to 9.0 percent.

The U.S. economy will return to growth by year-end after another severe contraction in the first quarter, Evans said. But employment, a trailing indicator, will take more time to recover. I think the unemployment rate will begin to decline sometime in 2010, he said.

AIG IN SPOTLIGHT

Bernanke, testifying to the House Committee on Financial Services, said the rescue of AIG helped avoid the risk of an outright financial market tsunami.

Its failure could have resulted in a 1930s-style global financial and economic meltdown, with catastrophic implications for production, income and jobs, he said.

AIG's evolving situation highlights the need for strong, effective consolidated supervision of all systemically important financial firms, Bernanke added.

At the same hearing, New York Fed President William Dudley said the Fed lacks the ability to control AIG on a day-to-day basis and must instead exert its influence over the company in its role as creditor.

These creditor's rights do not create an ability to manage AIG, Dudley said.

Questions about the running of AIG have become a sore point for the Fed, Congress and the White House after the company, which has been kept afloat by some $180 billion in government funds since September, recently paid out $165 million in executive retention bonuses.

The bonuses, many of which are now being repaid, were legal but extremely distasteful, Dudley said.

(Additional reporting by Michael Winfrey and Balazs Koranyi in Prague, Alister Bull and David Lawder in Washington and Tamawa Desai and Ian Chua in London; Editing by Andrea Ricci)

Inflation Ben Bernanke