(Updates with comments from Q&A)
By Kristina Cooke
MADISON, Wis., Jan 15 (Reuters) - The United States is in the midst of a "serious" recession and if credit markets and the economic outlook do not start to improve, the Federal Reserve may need to expand its use of unconventional policy tools, a top Fed policy-maker said on Thursday.
The Fed -- the U.S. central bank -- has more than doubled the size of its balance sheet to over $2 trillion, pumping hundreds of billions of dollars into key credit markets as it battles the worst financial crisis since the Great Depression.
"If credit market functioning does not improve, and if the outlook for economic activity does not begin to show signs of improvement, it may be necessary to use these nontraditional tools further," said Charles Evans, president of the Chicago Fed in prepared remarks to the Wisconsin Bankers Association.
"For example, it could be useful to purchase significant quantities of longer-term securities such as agency debt, agency mortgage-backed securities and Treasury securities to reduce borrowing costs for a range of longer-term instruments," Evans said.
Evans, who is a voting member of the policy-setting Federal Open Market Committee in 2009, said potential changes in the size and scope of emergency credit facilities could also help lower the cost of borrowing in targeted markets.
The collapse of the housing market and the financial crisis tipped the United States into recession in December 2007.
Evans expects gross domestic product growth to decline sharply in the first half of 2009 then recover slowly in the second half but he expected real GDP to decline for 2009 overall and the unemployment rate to likely rise into 2010.
"We find ourselves in the midst of a serious recession," he said, "One that may end up being more like the large downturns in the 1970s and 1980s than the more moderate contractions of 1990 and 2001."
Answering questions after the speech, Evans said that banks still face many challenges and that it is impossible to say how many more banks will fail.
He said banks' risk management has to improve dramatically and that increased supervision would be a part of that process. "We must get this right so that it doesn't happen again."
In his speech, Evans said it was important for the Fed to "continue to collaborate with policy-makers across the globe in the pursuit of financial stability worldwide."
"We likely are in for a protracted period of poor economic performance. But the policy actions taken by the Fed and other governmental agencies over the course of the financial crisis and the effort of the private sector to work through its difficulties will eventually help support a recovery in economic growth," Evans said.
The Fed cut its benchmark overnight funds rate target to between zero and 0.25 percent on Dec. 16, following an aggressive rate-cutting cycle that started in September 2007.
Evans said that once the economy recovers and financial conditions stabilize, the Fed will return to its traditional focus on the federal funds rate. It also will have to scale back the use of emergency lending programs and reduce the size of the balance sheet and level of excess reserves.
"Some of this scaling back will occur naturally as market conditions improve on account of how these programs have been designed. Still, financial market participants need to be prepared for the eventual dismantling of the facilities that have been put in place during the financial turmoil," he said.
Evans expects core inflation to slow "considerably" in 2009 and then edge down further in 2010. But he played down the risk of deflation. "I do not currently see much risk of an outright deflationary episode," he said.
Nevertheless, he joined a growing number of regional Fed presidents in calling for an inflation target.
"At a time when near-term inflation is likely to be lower than usual, having an explicit numerical objective for inflation could help keep inflation expectations from falling very far." (Reporting by Kristina Cooke; Editing by James Dalgleish)