The U.S. economy is grim, and the Federal Reserve is duty bound to apply every tool to clean up the financial system and clear a path for a return to sustainable growth, Richard Fisher, president of the Dallas Fed, said on Wednesday.

But he said monetary policy alone would not be enough to resuscitate the economy, adding fiscal stimulus was critical in providing a spark for U.S. growth.

Monetary policy accommodative techniques are necessary but insufficient to the task, Fisher told a symposium hosted by a private think tank in Tokyo.

The trick to fiscal policy is to provide the spark, to provide the right incentives, get the small and medium-sized firms create jobs again, create dynamism in the economy without planting the seeds of inflation.

Fisher, who is not a voting member on the Fed's policy-setting committee this year, said the U.S. economy probably shrank in the just-ended first quarter of 2009 at a rate similar to the 6.3 percent annual decline posted in the fourth quarter of 2008. He gave no timeline for a potential recovery.

The men and women who operate our businesses and create and sustain employment have assumed a defensive crouch, he said in a speech to the forum sponsored by the Japan Center for Economic Research in Tokyo. The result is an American economy in statis.

With firms doing all they can to cut costs, and especially the cost of labor, the jobless rate is likely to hit 10 percent by year-end compared with 8.5 percent in March, he said. Presently, the risk is deflationary job destruction.

With the world groaning with excess capacity, rising inflation will probably not be an issue for the next couple of years, Fisher said. The problem with regard to maintaining price stability most certainly is not inflation.

Fisher said the Fed has been dramatically proactive and highly innovative in attempting to resurrect the credit markets and halt the deep economic recession that started in the United States in December 2007.

We are duty bound to apply every tool we can to clean up the mess that our financial system has become, he said.

Although the Fed has run up its balance sheet dramatically and will do so further based on its current commitments, Fisher said fears that dollar-based fixed-income portfolios would be debased have been unfounded so far.

The problems facing the largest competitive currency, the euro, are perhaps even more substantial than those confronting the United States, he said.

Demand for U.S. Treasuries ... will be determined by their attractiveness relative to alternatives and they may be judged more, rather than less, attractive under most reasonable future scenarios.

The Fed is determined to short-circuit any inflationary consequence of its balance sheet growth, and is in the process of acquiring new tools to help, Fisher said.

We realize ... we are at risk of being perceived as monetizing the fiscal largess of Congress and that by intervening in mortgage-based securities and other markets could be seen as blurring the lines between fiscal and monetary policy -- a threat to the Fed's independence, he said.

(Additional reporting by Ros Krasny; Editing by Leslie Adler and Rodney Joyce)

Inflation