Top Federal Reserve officials hinted on Thursday that the long U.S. economic downturn could be in its final stages, although the early stages of recovery will likely be far from stellar.

Meanwhile, policy-makers showed a split on whether the Fed's current stance of aggressively pumping money into credit markets poses a major risk of stoking high inflation.

Dallas Fed President Richard Fisher, who terms himself the most pessimistic member of the Federal Open Market Committee at present, said the Fed's aggressive rescue efforts should soon stem the decline in growth.

Weakness could be tempered after the current quarter, which is likely to match the annualized contraction of 6.3 percent in gross domestic product seen for the dismal final quarter of 2008, Fisher said at a conference in Dayton, Ohio.

Gary Stern, Minneapolis Fed President, said that at least a mild recovery could take hold by mid-year before healthier growth kicks in during 2010.

Many pieces are now in place to contribute to improvement in financial market conditions and in business activity, Stern told the Economic Club of Minnesota. There is reason to think that improvement is not too far off.

Jeffrey Lacker, Richmond Fed President, offered recent increases in U.S. retail sales, lower gasoline prices and steady wages as signs for hope on the economy.

It is reasonable to expect the economy to hit bottom later this year and then begin a gradual recovery, Lacker said in Charleston, South Carolina.

Still, Dennis Lockhart, Atlanta Fed President, told Reuters in Paris that the recession would drag on for at least a few more months.

The significance of a recent run of better-than-expected economic data, including Wednesday's durable goods orders for February, should not be overstated, he said.

One month does not make a recovery, so we have to be careful not to react too strongly, Lockhart said.

INFLATION BALANCING ACT

Some financial markets participants fear the Fed's provision of huge amounts of liquidity to support the economy will fire up inflation when the economy eventually recovers.

The Fed's balance sheet, which as recently as mid-September 2008 stood at about $1 trillion, is now more than $2 trillion.

Just last week, the Fed vowed to provide the economy with an additional $1.15 trillion, partly by buying government bonds for the first time since the 1960s.

Charles Plosser, Philadelphia Fed President, told Reuters in an interview that a debate on how the Fed will shrink that balance sheet has to happen long before inflation flares.

Plosser also said that the composition of the balance sheet, as much as its size, troubled him and voiced support for buying Treasury bonds.

Bond purchases are more neutral in their effects on the allocation of credit than a number of other Fed programs which have targeted specific corners of the credit market.

Lacker, who along with Plosser is one of the Fed's biggest inflation hawks, seemed anxious to secure a commitment to run down the balance sheet as soon as possible.

Such a large increase in the monetary base cannot be left in place indefinitely without creating quite sizable inflation pressures, he said.

Choosing the right time to withdraw that stimulus will be a challenge and I believe it will be very important to avoid the risk of waiting too long.

Still, Stern, the Fed's longest-serving regional bank president, was less worried, saying the central bank had ample time to withdraw excess liquidity when the time was right.

The relation between growth in the money supply and the path of prices holds in the long run, over periods of at least five and, more likely, 10 years, Stern said.

In the short run, most officials agree that the Fed is buying some needed insurance against the threat of deflation resulting from the downturn in global economic activity.

Inflation expectations had remained pretty stable in recent months, and the Fed's big balance-sheet blow-out would ensure that deflation doesn't become an issue, Plosser said.

Lacker concurred. I am confident that we can prevent outright deflation by expanding our monetary policy stimulus if need be.

LOOKING BACK - AND FORWARD

As they are left to mop up the worst financial crisis in seven decades, some Fed officials concede that signs of an impending meltdown went unnoticed for too long.

Most in the financial community, including those of us at the Federal Reserve, failed to either detect or act upon the tell-tale signs of financial system excess, Fisher said.

Stern, meanwhile, termed the mortgage providers Fannie Mae and Freddie Mac were poster children for regulatory action taken way too late.

Without timely responses to financial crises, the costs to the real economy grow and grow, Stern said. You want to deal with these things as quickly, and forcefully, as you can.

(Additional reporting by Kristina Cooke in Philadelphia, Alister Bull in Charleston, Pedro Nicolaci da Costa in New York, Andrea Hopkins in Dayton and Anna Willard and Tamora Vidaillet in Paris; writing by Ros Krasny)

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