INTERVIEW-UPDATE 3-Fed's Bullard: Rate path depends on recovery

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By Nick Edwards and Naomi Tajitsu

LONDON, May 25 (Reuters) - A top Federal Reserve official said on Tuesday that European debt woes pose a risk to the U.S. economic recovery, but expressed confidence the danger of contagion was small.

"It's hard to see a banking crisis," St. Louis Federal Reserve Bank President James Bullard told Reuters Insider in an interview.

"It might be expensive, there might be other ramifications, but it's hard to see a global flare-up," he said.

In the interview and in a subsequent speech, Bullard said the willingness of governments to step in and prevent large financial firms from failing in recent years means that a repeat of the rippling financial stresses of 2007-2009 are unlikely.

"Governments have made it very clear over the course of the last two years that they will not allow major financial institutions to fail outright at this juncture," he told the European Economics and Financial Centre.

Bullard's comments reflect a Fed view that the biggest risk to the United States economic recovery from the European turmoil is a shock to financial markets rather than a slowdown in euro zone growth. He also noted that the United States derives some benefits as a safe haven for investors in a time of turbulence.

The Federal Reserve cut interest rates to near zero percent and pumped hundreds of billions of dollars into the U.S. financial system to combat a financial meltdown and a painful recession.

The U.S. central bank renewed its pledge to hold rates exceptionally low for an extended period at its most recent policy meeting in late April. Bullard, a voter on the Fed's policy-setting panel this year, said the Fed would watch the U.S. economy's progress through autumn and into 2011 as it decides how long it will hold interest rates at ultra-low levels.

Bullard repeated previous comments that the extended period promise is not a commitment to hold rates low for a specific time frame and could change depending on trends in employment, inflation and inflation expectations.

He acknowledged the Fed is watching the European situation for any impact on the U.S. economic recovery, which he said was on track.

"The economy is doing fairly well so far," he said. "We have some risk, we have the situation in Europe we're watching very closely, but we'll see how things proceed through the fall and into 2011."

In the latest Reuters poll, 10 out of 17 primary dealers -- the big banks that deal directly with the Federal Reserve -- saw the first Fed rate hike coming in 2011.

Europe's troubles have strengthened the case for the Fed to remain on hold, prompting some economists to push back their rate hike forecasts.

Bullard said the modest take-up of the Fed's currency swap facilities reopened earlier this month with other major central banks in response to worries about European sovereign debt defaults suggested there was less stress in the banking system than after the collapse of Lehman Brothers in September 2008.

"There is no question it's stressful, but it's nowhere near as stressful as in 2008-2009," he said.

He also noted that a rise in prices that investors pay to insure against default at major banks has been limited compared with the aftermath of the Lehman collapse.

Europe responded to a sovereign debt crisis that started in Greece with a roughly $1 trillion emergency loan package earlier this month, and the European Central Bank stepped in with debt purchases.

Bullard said there still were risks of the situation worsening, but euro zone guarantees for the region's banking sector would likely prevent such a situation.

"There is some risk that the European crisis will morph into something larger. But as of today, because of bank guarantees, I can't really see it going through into the global banking system," he said.

As the euro zone grapples with fiscal problems in Greece and other countries, Bullard said some form of sovereign debt restructuring in the 16-member bloc would not be disastrous.

"It can be done," he said. "It's very painful for the country ... and it can incite a lot of volatility in the markets, but it's not the end of the world by itself."

Despite his largely optimistic view, Bullard said instability is likely to remain a feature of financial markets for a while.

"Some of the problems we have faced over the last three years will simply remain with us, and so will the volatility associated with those problems," he said in his speech.

Bullard said that while inflation remains low for now, it would pick up if the U.S. recovery continues on track. He did not see any risks of deflation at the moment.

Core inflation, which strips out volatile food and energy costs and is closely watched by the Fed in gauging price risks, came in flat last month and has risen just 0.9 percent over the past 12 months, the smallest gain in more than 44 years. (Additional reporting by Mark Felsenthal in Washington, Editing by Leslie Adler