Published: Tuesday, 10 Nov 2009 | 12:42 PM ET

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Federal Reserve officials on Tuesday struck a cautious note on the U.S. economy, citing high unemployment, heavy reliance on government support and commercial real estate woes as hurdles to recovery.

Speaking less than a week after the Fed left interest rates unchanged at near zero, San Francisco Fed President Janet Yellen and Atlanta Fed President Dennis Lockhart said the economy was still vulnerable.

CNBC.com Janet Yellen

"The strength and durability of the expansion is in question," Yellen said in Phoenix, Arizona.

"High unemployment, weak job growth and paltry wage increases are a recipe for sluggish consumer spending growth and a tepid recovery," said Yellen.

The Fed chopped overnight interest rates to near zero in December and it has pumped more than $1 trillion into the economy to spur a recovery from the deepest downturn since the Great Depression.

Last week, it reaffirmed its commitment to keep borrowing costs ultra-low for "an extended period," and financial markets will be listening to Fed officials closely to try to gauge when they may finally move to withdraw their economic support.

Whether the private sector can pick up the slack once the government boost is gone also remains to be seen, Yellen said.

Lockhart, speaking at a Urban Land Institute conference in Atlanta, Georgia, said he believed the economic recovery was under way but added he expects the pace of growth to be "relatively subdued" in the medium term.

"The situation is much improved, but there are sobering aspects of the economic picture," Lockhart said, noting that the economy has been supported by temporary government programs and that data on bank failures, foreclosures, unemployment and personal income "continue to disappoint."

The Fed said last week that economic slack, subdued inflation trends and stable inflation expectations argued for a prolonged period of low rates.

Dennis Lockhart

A Reuters poll on Tuesday showed economists do not expect the Fed to raise rates until the third quarter of next year.

The Fed also emphasized three economic conditions to watch: resource utilization, inflation trends and inflation expectations.

Analysts said that highlighting these three conditions bolstered the Fed's case for keeping interest rates low for a long time.

In the bond market, the officials' remarks supported prices of Treasuries, easing investors' worries about higher interest rates in the near future.

In October, the unemployment rate - a way to track resource utilization -- unexpectedly surged to 10.2 percent.

Lockhart said he expects very slow job gains next year. "At this juncture, it's hard to be encouraged about a fast rebound in job growth," he said.

Answering reporters' questions after his speech, Lockhart said that there could be scenarios in which the Fed may have to tighten policy even with unemployment still "frustratingly high" if other economic conditions warrant a move.

In his speech, he said for now the overall objective of economic policy should be to bring about "a durable economic recovery and an environment that reduces unemployment as quickly as possible while containing inflationary pressures." He said there will have to be a "judicious removal" of government support.

Yellen said in her speech that she was not worried about inflation, arguing instead that the possibility of a problematic drop in consumer prices was the greater risk.

Both Yellen and Lockhart flagged the prospects for commercial real estate as worrisome and said the banking industry was far from healthy.

Lockhart said commercial real estate's problems could slow the pace of recovery and said the link between bank lending, small business employment and commercial real estate values was a concern.

Also speaking Tuesday was Boston Federal Reserve Bank President Eric Rosengren.  He said that large global banks continue to pose risks for policy-makers, and requiring them to be capitalized separately at home and abroad may help ease some concerns, in remarks prepared for delivery to a seminar in London.

"Banks that are global, not just large, can create additional complications -- they are more difficult to resolve and can 'export' capital adequacy problems ... to countries that host their operations," Rosengren said. A text of his remarks was made available in Washington.

Meanwhile, Federal Reserve Governor Daniel Tarullo on Tuesday endorsed the idea of requiring big banks to hold more capital and renewed his suggestion that direct efforts to limit the size of banks may be worth considering.

Fed Chairman Ben Bernanke and other officials have raised the idea of a capital surcharge to prevent banks from getting so big that the government is compelled to prop them up in a crisis.

The idea 'has substantial appeal,' Tarullo said in remarks prepared for a speech at New York University.

The Fed governor said that in the debate over reforms to prevent a repeat of the recent financial meltdown, policy-makers could also focus on changes to the structure of the financial system as well as regulations.

He said both regulators and the financial industry were to blame for the crisis. He renewed his suggestion that directly limiting the size of financial institutions may have merit.

Lawmakers are considering an overhaul of financial rules in the wake of a devastating crisis that triggered a painful recession, and Tarullo has been the Fed's point person in that debate.

A key U.S. Senator, Banking Committee Chairman Christopher Dodd, unveiled his proposal for financial reforms on Tuesday.

• Jobless Rate to Hit 10.5%, Keeping Fed in Box: Poll

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