The U.S. recession should end in the second half of 2009 but the Federal Reserve needs clearer signs of sustainable growth to start reversing course on policy, Chicago Fed president Charles Evans said on Wednesday.

The possibility that the economy is closer to a turning point is stronger now than just three months ago, Evans said in a speech to the Chamber of Commerce of St. Joseph County in South South Bend, Indiana. Activity is bottoming out.

We expect modest increases in output in the second half of this year followed by somewhat stronger growth in 2010.

Evans, a voting member of the Federal Open Market Committee in 2009, suggested Fed policies -- both conventional and unconventional -- are on hold for now:

In the absence of unexpected shocks and changes, I don't foresee the need for any major changes to the policy parameters of the programs, and I view us in a wait and see mode.

Evans did not anticipate inflation flaring up in the short run given weak labor markets and low capacity utilization.

I think the downward forces on inflation will be greater than the upward forces, and we could see some declines in core inflation. But over the medium term I see the risks to the inflation forecast as being more balanced, he said.

Evans acknowledged the sharp run-up in the Fed's balance sheets, flooding markets with money, could create worries that inflation will rise, but said there is no middle link in the chain that has led from credit expansion to inflation in the past.

Inflationary pressures will not arise without broader credit expansion, and there is no evidence for that at present, he said.

Evans said that recent economic data have been uneven but consistent with the idea that the pace of contraction is slowing and that activity is bottoming out.

Improved conditions in financial markets, and stabilization in consumer spending and housing markets, all point to a more stable economy, he said.

Labor markets remain weak, but there has been a (somewhat uneven) decline in the pace of job losses, Evans said.

Still, with firms reluctant to hire, the U.S. jobless rate, which hit 9.5 percent in June, will likely further increase through the remainder of the year before it flattens out in 2010, he added.

In the months ahead, a turn in the inventory cycle as inventories better align with sales should translate into a net positive for GDP growth, Evans said.

The policy-maker said that some of the Fed's many programs will shrink naturally as market conditions improve.

Still, a significant portion of the balance sheet will likely not shrink on its own, or at the appropriate pace, forcing the central bank to gear up its exit strategy.

We need tools to manage it actively, so that monetary policy can be more easily calibrated. In this respect, we can be as creative on the way out as we were on the way in, Evans said.

Even though inflation risks for now are to the downside, Evans noted that inflation has not fallen to the extent that might have been expected given the severe recession.

As economic conditions improve, consumers and businesses might expect upward pressure on inflation, Evans warned.

Experience shows that a rise in inflation expectations, once solidified, becomes embedded in many economic decisions and makes inflation harder to control.

Core inflation near 2 percent is a level I generally find acceptable, Evans added.

(Editing by James Dalgleish)