UPDATE 2-Fed's Lacker says recession to end later this year

CHARLOTTESVILLE, VA., May 4 - The U.S. recession is fading and growth will resume later this year but the Federal Reserve must not wait too long before tightening monetary policy, a top Fed official said on Monday.

"While overall activity is still contracting, it now appears as if the pace of contraction is diminishing, and at some point later this year, activity will bottom out and begin expanding again," Richmond Federal Reserve President Jeffrey Lacker said in a speech to business leaders.

Lacker, a voting member of the Fed's policy-setting committee this year, said stable price expectations should keep the risks of deflation at bay. But the Fed should not take risks with inflation by waiting too long to tighten policy.

He said the central bank has delivered "an extraordinary, unprecedented monetary expansion" after slicing interest rates almost to zero and adding over $1 trillion to its balance sheet to bolster credit markets.

"The challenge for us on the Federal Open Market Committee will be be to shrink our balance sheet and tighten policy soon enough when the recovery emerges to prevent rising inflation.

"The danger is that we will not shrink our balance sheet and tighten policy soon enough ... I believe it will be very important to avoid the risks of waiting too long or moving too slowly," he said.

But Lacker, regarded as one of the Fed's most hawkish policy-makers for dissenting in favor of tighter policy in the past, did not sound especially worried about inflation and stressed expectations were well anchored around 2 percent.

Lacker was also pretty confident that, thanks to the resiliency of U.S. consumers, and the powerful policy stimulus delivered by the Fed, growth would resume before year-end.

He said the U.S. residential housing market looked to be steadying, while measures of business investment had picked up in recent months and manufacturing appeared to have gotten past the worst part of that sector's decline.

"If the emerging stability in housing and consumer spending persists, as I expect, some segments of business investment spending should bottom out by the end of the year and economic growth then would turn positive.

"I expect the labor market to continue to weaken, however, and overall spending is likely to bottom well before the unemployment rate peaks," Lacker said.

More than 5 million U.S. jobs have been lost since the recession began in late 2007 and the rate of unemployment spiked to 8.5 percent in March, while U.S. growth shrank by 6.1 percent in the first quarter.