The Federal Reserve's James Bullard said on Thursday he did not expect the fiscal crisis in Europe to create problems for the U.S. economy, but said the Fed's vow to keep rates low for a long time could, if misread, create risks.

In a speech to bankers in Stockholm, Bullard, President of the St. Louis Federal Reserve Bank, warned that the Fed's pledge to maintain unusually low rates for an extended period could, if misread, perpetuate the boom and bust cycle that plunged the United States and the world into recession.

Markets may confuse the policy with the 'interest rate peg' policy, in which rates do not adjust in response to shocks, Bullard said. In particular, multiple equilibria or 'bubbles' are possible.

Until recent weeks the market's chief concern was how the Fed would unwind the ultra-accommodative policy it had put in place after the global financial crisis erupted in 2008.

Since then, worries about a fiscal crisis in southern Europe have taken center stage, jolting markets around the world.

Bullard saw one bright spot for the United States from Europe's woes, saying there had been a flight to safe assets and that was pushing down longer-term interest rates.

Right now, I think the U.S. is going to be a beneficiary of the crisis in Europe, barring any contagion, and I'm arguing that I don't see how the contagion could occur, Bullard told reporters after his address, noting debt guarantees European authorities had put in place.

He said U.S. policy makers were watching the situation carefully and he was open to the possibility that contagion could occur though an unexpected channel.

He said the U.S. economic recovery was on track.

I think consumers are generally feeling better about the U.S. economy. A lot of that has to do with the return of job growth in the U.S., which is projected to continue and I would expect consumer confidence to continue to improve, at least based on what we have right now.

Despite noting risks associated with the Fed's pledge to keep rates low, Bullard has backed the central bank's decision to renew that pledge at its April meeting.

On Thursday, Bullard noted the policy can be successful at providing additional stimulus to an economy when borrowing costs are near zero, as they have been in the United States.

Since the Fed's April meeting, evidence the U.S. economic recovery is accelerating has increased. New U.S. home sales have reached a two-year high and durable goods orders surged in April.

The U.S. central bank cut rates to the bone in December 2008 and then flooded the financial system with hundreds of billions of dollars to pull the economy out of the worst crisis since the Great Depression.

EXIT STRATEGY

Bullard, a voter on the Fed's policy setting panel, is not viewed as one of the most stringent inflation hawks among U.S. policymakers.

However, he has emerged as an advocate for quickly shrinking the Fed's extensive quantitative easing efforts by selling off some of the mortgage-related debt the central bank has bought.

Flooding financial markets with bank reserves to induce economic growth, as the Fed's asset purchases did, can cause inflation if markets lose faith in a central bank's commitment to drain reserves in a timely manner, he said in Stockholm.

The consensus view at the Fed, reflected in comments by Fed Chairman Ben Bernanke, is that its bloated balance sheet will shrink naturally as the assets mature or are paid off.

Bernanke has said that sales of assets are only likely after the Fed begins to raise interest rates, although most Fed policymakers now agree it would be advisable to sell some of the roughly $1.4 trillion in mortgage-related debt the Fed bought.

Bullard was among three Fed officials who sought an increase in the Fed's discount rate in April.

The discount rate is the rate the Fed charges for banks to borrow and is different from the interbank lending rate, or Fed funds rate, that it targets to steer the economy.

Bullard told reporters that while he wanted to get policy spreads in the United States back to more normal levels, he did not see the discount rate rising in the current environment.

(Reporting by Mark Felsenthal, Adam Cox and Mia Shanley; Editing by Susan Fenton)

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