The economy is showing signs of improvement but the recovery still has a long way to go and ultra-low interest rates are still needed, a top Federal Reserve official said on Wednesday.

Boston Federal Reserve Bank President Eric Rosengren said in a speech to the Money Marketeers of New York University that even with more positive recent economic data, the economy remains vulnerable to negative shocks.

He said he agrees with forecasters who expect disinflation -- a reduction in the rate of inflation -- in the near term.

With inflation expectations stable, core PCE inflation rates declining and significant excess capacity in the economy, accomodative monetary policy remains appropriate, he said.

Rosengren, seen as one of the more dovish Fed officials, more focused on economic growth than the risks of inflation, is a voter on the Fed's policy-setting Federal Open Market Committee this year.

The Fed cut interest rates to near zero in December 2008 and has kept them there since to aid economic recovery. It also pumped billions of dollars into the financial system by buying longer-term assets, more than doubling its balance sheet to over $2 trillion.

Rosengren spent much of his speech countering concerns that the Fed's extraordinary policies could fuel inflation once the economic recovery gathers steam. He said it would be unusual to see the inflation rate increasing in the early stages of the recovery.

Even with rapid growth in the economy, spurred by accommodative monetary policy and stimulative fiscal policy, it is likely to take years before we approach the growth and inflation rates that would really reflect achievement of the two elements of the Federal Reserve's dual mandate, Rosengren said. The Fed's dual mandate is price stability and full employment.

He argued that even if bank lending picked up dramatically, the Fed has the tools it needs to drain the excess reserves it created in its fight against the financial crisis.

We have a variety of tools. We could sell some of our long-term assets, thereby increasing longer-term interest rates. We now pay interest on reserves, and that rate could be increased to discourage bank lending, Rosengren said.

Once banks have recapitalized and economic resources are more fully utilized, Rosengren said he would not want to have a large stock of excess reserves in the system.

Asked by the audience whether he would prefer to raise interest rates or sell assets first when the time comes to tighten monetary policy, he said:

My personal preference would be to start with short-term interest rates.

Rosengren would not rule out the Federal Reserve extending currency swap lines to Europe to help them cope with the Greek debt crisis. I wouldn't foreclose on any option... Hopefully it won't be necessary, he said in response to an audience question..

ASSET BUBBLES?

In his speech Rosengren said the Fed should be vigilant in monitoring for asset bubbles, but that he sees no such problems emerging at the moment. If asset bubbles were to emerge, it would be best to counter them in a targeted way through supervisory tools, he said.

In Washington earlier on Wednesday, Thomas Hoenig, president of the Federal Reserve Bank of Kansas City said policymakers need to act quickly to enact hard rules to limit the amount of leverage financial institutions can take on or risk another financial crisis.

If we take action now, then when the next economic correction occurs there will be less devastation to our economy, Hoenig said in prepared testimony to be delivered Thursday to the House Financial Services Subcommittee on Oversight and Investigations. A copy was obtained by Reuters.

If we don't change policy now, then this crisis will be remembered only in textbooks and leverage will rise again and lead to another crisis, Hoenig said.

While Hoenig was referring specifically to regulatory policy, he has also been one of the most vocal proponents of the need for Fed interest rate hikes to avoid fueling bubbles in financial markets.

Philadelphia Federal Reserve Bank President Charles Plosser also in Washington on Wednesday, told lawmakers regulators had been humbled by the financial crisis.

But he cautioned against regulatory reforms that would cut the Fed's supervisory power over smaller banks, saying this would run the risk of the Fed losing its Main Street perspective and exacerbate the problem of the biggest firms being perceived as too big to fail.

In remarks to a Joint Economic Committee staff meeting, Plosser also reiterated the need for a credible process of dealing with failed financial firms and warned of the dangers of politicization of the Fed, the U.S. central bank.

Inflation