UPDATE 2-Fed's Bullard warns inflation won't ease US debt burden

* U.S. cannot ease debt burden by "surprise" inflation - Bullard

* Says investors signal they think Fed may allow inflation above 2 pct

* Inflation would impose costs on savers, higher interest rates in future

(Adds Bullard comments to reporters, audience)

By Alister Bull

MEMPHIS, Oct 4 (Reuters) - The United States faces a debt problem, but any suggestion that the burden can be eased by allowing inflation to rise will just result in higher borrowing costs in the future, a senior Federal Reserve official said on Thursday.

James Bullard, president of the Federal Reserve Bank of St. Louis, said that inflation was sometimes seen as a way to "partially default" on existing debts, because it lowers the amount the borrower repays in real, inflation-adjusted terms.

"A partial default today through higher inflation would be paid for via higher inflation premiums in future borrowing. Creditors would want to protect themselves against an unpredictable central bank," he told the Economic Club of Memphis.

"Alas, in economics there is no free lunch," he said, quoting Nobel Prize-winning economist Milton Friedman.

Bullard is not a voting member of the Fed's policy-setting committee this year, but will hold a rotating vote in 2013.

"Is this happening? Distant inflation expectations from the TIPS (Treasury inflation protected securities) market seem to suggest that investors do not completely trust the Fed to deliver on its 2 percent inflation target," he said.

The U.S. has been slowly recovering from the deep 2007-2009 recession, which was caused by a collapse of the housing market that triggered a devastating global financial crisis.

Many U.S. households were left owing more on their homes than the properties were worth. At the same time, the U.S. government has aggressively expanded spending to shield the country from an even deeper downturn, widening the deficit and driving up national debt.

Bullard has publicly stated that he would not have voted for the Fed's third round of so-called quantitative easing announced at its policy meeting last month, at which it also committed to holding interest rates near zero until at least mid-2015.

The Fed also promised that it would keep rates ultra-low even as the economy strengthened, in order to ensure that stubbornly high U.S. unemployment was brought back to more normal levels, so long as inflation remained under control.

The national unemployment rate was 8.1 percent in August. The Labor Department will release the September employment report on Friday.

Bullard said that any effort to inflate away the debt problem would impose severe costs on the people who had lent the money, or on those who lived on fixed incomes.


"The partial default would occur against savers, mostly older U.S. households, and against foreign creditors," he said.

Fed critics say that its $2.3 trillion purchases of Treasuries and mortgage-backed bonds, plus September's decision to buy another $40 billion of mortgage-backed securities every month until hiring picks up, will severely sap the value of the U.S. dollar.

Fed activism has also been caught up in the U.S. presidential election, turning the central bank into a lighting rod for critics of big government who complain 'Washington' is intruding too far into the private sector's space.

Bullard, whose Federal Reserve district embraces states in heartland America far from both coasts, acknowledged public concern about "what the heck is going to happen next" that could harm confidence in the central bank.

"I would very much like to get out of the kind of crisis mode that we've been in. You know, after four years it is not a crisis any more. (We've) had plenty of chance to adjust at that point," Bullard told the audience during a question-and-answer session.

Minutes of the FOMC's September meeting released earlier on Thursday also showed that many committee members favor a commitment to lower the jobless rate beneath a certain level before raising interest rates, in order to better communicate its determination to bolster U.S. growth.

However, making clear this vision was not without opposition, Bullard said he had problems with that approach.

"I think we should be very cautious about tying monetary policy explicitly to the unemployment rate," he told reporters on the sidelines of the dinner event, warning that the Fed could find itself in a policy "box" with such an approach.

(Reporting by Alister Bull; Editing by Paul Simao)


Messaging: alister.bull.thomsonreuters.com@reuters.net))