A tepid economic recovery should allow the U.S. Federal Reserve to keep interest rates at rock-bottom lows for a prolonged period, New York Federal Reserve President William Dudley said on Monday. Because the U.S. economy faces many headwinds, including an anemic labor market and a fragile banking system, Dudley said, inflation will not become a problem in the foreseeable future.

The recovery will turn out to be moderate by historical standards, Dudley said in remarks prepared for delivery at Fordham Law School. The banking system has still not fully recovered.

Given the vulnerability of financial institutions, falling commercial real estate values will continue to pressure profits, putting a damper on lending, said Dudley, whose role at the New York Fed includes direct supervision of banks. Dudley's outlook for the economy was cautiously sanguine. He touted a rebound in financial markets that has seen major U.S. stock indexes surge more than 50 percent from their March lows, saying a virtuous cycle was replacing the vicious circles that brought the global financial system to the brink last year.

He also said he believes that forecasts for a 3 percent rate of annualized economic growth in the second half of this year are reasonable.

Slack galore

Despite the prospect for growth, Dudley highlighted the many factors that are likely to keep the economy operating below its full potential in the near future, and which should therefore help to keep inflation at bay.

The unemployment rate is much too high. This means the economy has significant excess slack and implies that we face meaningful downside risks to inflation over the next two years, said Dudley, a former economist at Goldman Sachs.

The trick for policymakers, he added, is to keep monetary policy at its highly stimulative stance without boosting inflation expectations of consumers and investors.

The best way to do that, argued Dudley, is to make a clear case for the Fed's ability to tighten policy, even with central bank credit to the banking system -- also known as the institution's balance sheet -- flirting with record highs above $2 trillion.

Faced with the worst financial crisis since the Great Depression, the Fed sharply ramped up its lending to financial institutions, launching a number of emergency lending facilities aimed at reviving interbank lending.

Dudley maintained that such largess can be easily reversed by new Fed tools like the ability to pay interest on bank reserves. By raising that rate, the Fed can discourage lending if it believes it has picked up to the point of presenting an inflation risk.

If that strategy fails, the Fed is working on other measures -- like reverse repurchase agreements and a term deposit facility -- that could rein in credit in the economy, said Dudley.

A more drastic option is also available, although it would not come without the risk of destabilizing markets.

The Federal Reserve could always drain reserves the old-fashioned way, by selling assets, Dudley said.

(Editing by Leslie Adler)