Fed Governor Daniel Tarullo said Europe's debt woes, if not contained, could cause financial markets to freeze and spark a global crisis akin to the market meltdown of late 2008.
Until last week, Fed officials had been playing down the possible impact to the United States from Europe's turmoil.
The European sovereign debt problems are a potentially serious setback, Tarullo said in testimony prepared for deliver to two congressional subcommittees.
Thursday marked another turbulent day in global financial markets. U.S. stocks plunged about 2.5 percent and investors fled from risky assets around the world. The euro, which this week hit a four-year low, was again under pressure.
Investors' anxiety still centers on Greece, but fears have grown that even the roughly $1 trillion emergency fund put together by the Europe Union and the International Monetary will not be enough to solve Europe's debt problems.
Investors are aware that this package cannot ultimately relieve the need for real, and likely painful, fiscal reforms in the euro area, said Tarullo.
The remarks were an unusually detailed pronouncement on economic matters from a Fed governor who tends to focus on regulatory issues.
If sovereign problems in peripheral Europe were to spill over to cause difficulties more broadly throughout Europe, U.S. banks would face larger losses on their considerable overall credit exposures, Tarullo said. In addition to imposing direct losses on U.S. institutions, a heightening of financial stresses in Europe could be transmitted to financial markets globally.
To some extent, financial markets are already showing signs of increased strain, buttressing the view of those who believe the Fed will likely leave U.S. interest rates near zero percent until sometime next year.
The U.S. economy has been recovering relatively quickly since hitting a bottom in the summer of 2009. Gross domestic product, the broadest measure of total economic output, jumped at a 3.2 percent annual rate in the first quarter.
But that recovery could be pressured by a reduction in global trade if the European outlook worsens, Tarullo said.
Ted Truman, a former Treasury official who is now a senior fellow at the Peterson Institute, and who will testify to the congressional subcommittees following Tarullo, said the threat is very real.
The risk is that the European situation will spiral out of control, spread within Europe beyond Greece and push Europe back into recession, and further damage the U.S. and global economy and financial system, he said in his prepared testimony.