Supervisory powers over banks are critical for the Federal Reserve to do its job, Minneapolis Fed President Narayana Kocherlakota said on Tuesday.

In comments that largely echoed those made in St. Paul on February 16, Kocherlakota said that a plan under consideration by U.S. lawmakers to remove those powers would be a mistake.

The improvement in our economic situation is attributable in large part to actions taken by the Federal Reserve, actions that were possible because of the expertise and information that the Federal Reserve had acquired as a supervisor of the nation's banks, he said in remarks to a business group in Minneapolis.

We avoided an economic depression this time. But stripping the Federal Reserve of its supervisory role would needlessly put a Great Depression on the menu of possibilities for our country.

While the current crisis was fueled by risk-taking at large banks, Kocherlakota said, the Fed needs to have access to information about small banks as well -- a point not included in his maiden speech as Minneapolis Fed president last month.

The government will likely respond to the recent crisis by tightening controls on larger banks, he said.

Inevitably, these constraints will lead risk-taking to move from large financial institutions to smaller ones, and will increase the probability of a financial crisis in the small institutions, he said.

Indeed, even now, the collective exposure of many smaller banks to commercial real estate may be exerting a significant drag on the overall economic recovery, he said.

Kocherlakota repeated his view the U.S. economy will likely grow at an annual rate of 3 percent over the next two years, and that unemployment will likely still exceed 8 percent at the end of next year.

Mitigating such trends, he reiterated, is relatively tame inflation -- suggesting he sees a smaller likelihood the Fed will need to raise interest rates to rein in unwanted price increases.

The Fed lowered its overnight bank-to-bank lending rate target to near zero in December 2008 to help fend off the worst U.S. economic downturn since the Depression, and has pledged to keep rates there for an extended period.

Kocherlakota will rotate into a voting spot on the Fed's monetary policy-setting Federal Open Market Committee next year.

(Editing by Chizu Nomiyama)

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