Keeping expectations of future price levels intact is vital, especially when interest rates are very low, the Federal Reserve's number two official said on Friday.

Fed Vice Chairman Donald Kohn also said that trying to counter asset price increases could increase volatility in inflation.

Having inflation expectation anchored in this situation (zero interest rates) is really critical, Kohn said in a speech at an European Central Bank seminar honoring retiring ECB Vice-President Lucas Papademos.

Risking unanchoring of expectation would be far too risky and far too costly. No one has done it and it is understandable why.

Central banks' non-traditional measures should be conditional on inflation and economic development, he also said.

It's really critical that it (unconventional policy) is seen as conditional on inflation and output and development of the economy. It is a good tool, and it worked, but you have to use it right.

Asset buys by central banks are most helpful when markets are not functioning by themselves, he also said.

Central bank purchases of assets are particularly useful when markets are illiquid.

Kohn also warned that ensuring price stability will not necessarily ensure financial stability.

Price stability is not sufficient for financial stability and sometimes can work against it.

But trying to counter rising asset prices was risky and added to increased moves in inflation rates.

Judging when an asset is getting away from its fundamental value is almost impossible, Kohn said.

If you lean against these things you will get more volatility in output and inflation.

While asset prices and interest rates are related, it is much more difficult to assess how close the relation between interest rates and speculation is, he added.

(Reporting by Krista Hughes, writing by Sakari Suoninen; editing by John Stonestreet)

Federal reserve Inflation