By Ros Krasny

Well-functioning credit markets remain critical to any economic upturn, and the Fed may need to expand its use of unorthodox policy tools, the officials said.

Janet Yellen, President of the San Francisco Fed, said the central bank would not let inflation fall below one percent, and that setting inflation targets would be "one way" to convey the Fed's commitment to a turnaround.

"We need to make it clear that would be undesirable, unwelcome and we would fight it," Yellen told reporters after a speech to the Financial Women's Association in San Francisco.

In Madison, Wisconsin, Chicago Fed President Charles Evans also endorsed the concept of an inflation target, a policy idea mothballed by the Fed until recently.

"Having an explicit numerical objective for inflation could help keep inflation expectations from falling very far," he told the Wisconsin Bankers Association.

Evans said the United States is "in the midst of a serious recession" and listed possible steps the central bank could take if the economy and credit markets do not improve.

"It could be useful to purchase significant quantities of longer-term securities such as agency debt, agency mortgage-backed securities and Treasury securities," he said.

WE'RE PRINTING MONEY. SO WHAT?

The FOMC lowered its benchmark overnight funds rate to a range of between zero and 0.25 percent on December 16, ending a rate-cutting cycle that started in September 2007, when the funds rate was at 5.25 percent.

Rate cuts have been complemented by a raft of programs designed to improve the flow of credit to the private sector and most recently, to support mortgage-backed securities.

Yellen said the Fed's policy steps would be more successful than the "quantitative easing" practiced by Japan's central bank in the 1990s because they are focused on individual sectors of the credit market that are under particular strain.

"We're trying to understand where the breakdowns are, and target the facilities at where the breakdowns are," she said. "You can call it printing money if you want."

A number of the Fed's programs are due to sunset at the end of April, but Yellen said they would probably be extended until no longer necessary.

She joined Minneapolis Fed President Gary Stern who, on Wednesday, said the programs, and the massive expansion of the Fed's balance sheet to over $2 trillion, posed little inflation risk over the medium term.

Some of the Fed's more ardent inflation hawks have urged a clearly-defined exit strategy to head off the risk of a surge in inflation, but Yellen said that was a distant scenario.

"When the economy is operating close to its capacity that would drive up inflation. That's not our situation now. We've got quite the opposite," she said.

Evans said a scaling-back of the Fed's balance sheet and a return to the traditional focus on interest rates as a policy tool would happen over time.

"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.

BANKS ON THE BRINK

Rumors swirled on Thursday about the fate of some of the largest U.S. banks, with shares in Bank of America Corp and Citigroup Inc tumbling on worries about their ability to handling soaring credit losses.

Both banking giants face questions from investors about how they will manage a surge in loan losses caused by the deepening recession, which has driven up joblessness and home foreclosures.

Atlanta Fed President Dennis Lockhart said on Thursday he expects the government to make fresh capital injections if it wins backing for more public aid.

"Banks remain under stress, so it would be hard to predict that there will be no more failures," Lockhart told an event at the University of Southern Mississippi in Hattiesburg.

"If the second $350 billion tranche of the TARP (Troubled Asset Relief Program) in fact is deployed, in all likelihood, some of that will be deployed to inject further capital into banks," said Lockhart.

Yellen said banks are caught in the economy's downdraft and will face more bad loans for longer than was first anticipated, just as the downturn looks like dragging on for longer than earlier guessed.

Yellen told reporters it would be "perfectly possible" to see a return to growth in the U.S. economy late this year but that unemployment would stay high into 2010, making the first stages of a recovery weak.

Lockhart, Evans and Yellen are all voting members of the Federal Open Market Committee in 2009.

In Washington, President-elect Barack Obama's choice to fill a seat on the Federal Reserve Board said that many U.S. financial firms appear to need more capital.

"My strong suspicion is that capital levels at many institutions are not where we want them to be, Daniel Tarullo, a professor at Georgetown University, said at his confirmation hearing before the Senate Banking Committee.

(Additional reporting by Kristina Cooke in Madison, Evelina Shmukler in Hattiesburg and Emily Kaiser in Washington)