The U.S. recession is likely to grind on for some time, especially as strains in credit markets continue, a top Federal Reserve policy-maker said on Thursday.

But Gary Stern, President of the Minneapolis Fed, said he was confident that business activity would pick up before too long, leading to a mild rebound that could gather more strength from mid-2010 onward.

The recession is likely to persist for some time longer, and the initial stage of the recovery seems likely to be subdued, Stern said in remarks prepared for the South Dakota economic summit in Sioux Falls.

Stern, who is 64 and is the Fed's longest-serving regional president, said last week he will retire this summer. He is not a voting member of the Federal Open Market Committee in 2009.

Despite aggressive actions by the Fed and other agencies that seem to be showing success, Stern said appreciable strains continue in credit markets -- a roadblock to recovery.

The reallocation of resources that should occur in a recession and that is fundamental to economic recovery is inhibited when financial markets are not functioning or are functioning poorly. Unless conditions improve, such market failures threaten to prolong the recession, he said.

Among positives for the U.S. economy, in recession since December 2007, Stern cited signs consumer spending is stabilizing after lurching sharply lower in the fourth quarter of 2008.

Progress has also been made in working off the inventory of unsold, unoccupied homes, while the Obama administration's fiscal stimulus should boost demand in a timely way, he said.

In view of the state of the credit markets, it seems a fair bet that it will take time for momentum to build. But ... as we get into the middle of 2010 and beyond, I would expect to see a resumption of healthy growth.

Echoing his recent comments, Stern said that worries about either inflation or deflation could not be dismissed out of hand but neither should it develop into a huge problem.

If economic growth resumes in the United States as I expect, the threat of deflation should diminish commensurately, he said.

As for the possibility that a massive increase in the Fed's balance sheet will sow the seeds of an inflationary spiral, Stern was skeptical.

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 ten years. Thus, there is ample time to withdraw excess liquidity as appropriate, he said.

Stern repeated his call to tackle the issue of too big to fail, or the way large institutions have taken on excessive risk on the assumption they will be bailed out.

Proposals to address the concept merely by shrinking the largest financial institutions or tightening supervision would be a waste of time, he said.

(Writing by Ros Krasny in Tulsa; Editing by James Dalgleish)