The U.S. Federal Reserve will have to raise interest rates as the economy improves or risk losing the public's confidence in its commitment to keeping inflation low and stable, a top Federal Reserve policy maker said on Tuesday.

Charles Plosser, president of the Philadelphia Federal Reserve Bank, said expectations for future inflation are currently well-anchored, but warned that there is considerable uncertainty clouding the outlook for price pressures over the next two to five years.

Plosser, known as an anti-inflation hawk, reiterated that Fed policy must be preemptive, in remarks prepared for delivery to the Entrepreneurs Forum of Greater Philadelphia.

As monetary policy works with a lag, officials need to consider what the inflation outlook will be and how the economy will look in 2011 and beyond, he said.

I believe the Fed will need to withdraw the extraordinary amount of liquidity it has provided to the economy and begin to raise interest rates as the economy continues to improve and financial markets return to more normal operation, he said.

If it fails to do so, rising inflation expectations could prompt workers to demand higher wages and firms to demand higher prices to head off the expectation of higher costs, thus setting off a burst of inflation.

The Fed cut the federal funds rate -- the benchmark U.S. interest rate -- to near zero percent in December 2008. It has also put in place a raft of emergency programs, including one to purchase $1.25 trillion worth of mortgage-backed securities to help guide the U.S. economy out of the worst recession in some 70 years.

The Fed has pledged low rates for an extended period and most analysts do not expect the Fed to raise interest rates until the second half of 2010.

A few Fed officials have suggested continuing or expanding the mortgage-backed securities purchases beyond their scheduled completion at the end of March to nurture a weak recovery and to prevent potential disruptions to housing markets from the end of the program.

Plosser said the Fed should end the MBS purchase program by the end of March as planned.

I believe it is important that we do so, and reduce our participation in this market, so the private market can once again resume a significant role. It cannot do so as long as the Fed is the dominant player, he said.

If the Fed's purchases were to continue it would risk delaying the return to normal market functioning, he said.

Plosser, who will be a voter on the Fed's policy-setting panel in 2011, repeated his view that the Fed should raise its target federal funds rate before the jobless rate -- currently at 10 percent -- has returned to acceptable levels.

The Philadelphia Fed chief expects the economy to grow between 3-3.5 percent over the next two years, putting upward pressure on inflation-adjusted -- or real -- interest rates.

As long as inflation is near its desired level and inflation expectations are well-anchored, the targeted federal funds rate should increase as well, he said.

This increase in rates must occur well before the unemployment rate or other measures of resource slack have diminished to acceptable levels, he said.

Otherwise the Fed risks keeping interest rates too low for too long, potentially distorting asset prices and sowing the seeds of another crisis, he said.

Plosser said that while full economic and financial market recovery will take time, evidence that the recovery will be sustainable is increasingly broad-based.

Gross domestic product growth data suggest that the recession is likely over and the economy is in recovery -- perhaps not as strong a recovery as some in the past but one that I believe will be sustainable even as the fiscal and monetary stimulus programs eventually wind down, Plosser said.

Home prices appear to have stabilized and monthly data on consumer spending has shown encouraging increases in consumer spending outside of autos and gasoline, he said.

The jobless rate -- which typically lags the overall economic recovery -- will begin to fall by the end of 2010, but may tick up before beginning a gradual decline, he said. It will likely be some time, however, before the jobless rate returns to more acceptable levels, he said.

(Reporting by Kristina Cooke; Editing by Leslie Adler)

Inflation