NEW YORK — The Federal Reserve could increase key rates toward 1% from near 0% as a ward against inflation and possible bubbles in financial markets without hurting the nascent economic recovery, a Fed official said Wednesday.

The lone dissenter on the rate-setting Federal Open Markets Committee said 1% rates, toward which the Fed should move "sometime soon," would still represent "highly accommodative" monetary policy.

"This would require initiating a reversal of policy earlier in the recovery, while the data are still mixed but generally positive," said Thomas Hoenig, president of the Reserve Bank of Kansas City.

The current Fed policy that states key rates will remain ultralow for an "extended period" is no longer needed, Hoenig said at a luncheon in Santa Fe, N.M., delivering a speech from a prepared text entitled, "What About Zero?"

"By itself, the current state of the economy warrants an accommodative monetary policy," Hoenig said. "However, as the economy continues to improve, risks emerge around the act of holding rates low for an extended period."

Hoenig said he dissented from the "extended period" language at the past two FOMC meetings because of concern that artificially low rates can create fiscal imbalances, leading investors to invest cheap money based on the expectations of the key federal-funds rate being held near 0%.

The market, Hoenig said, interprets "extended period" to mean at least six months.

Interest rates set near 0% for too long could lead to a new bubble and an inevitable bust, or even financial collapse, he said.

While Hoenig said he couldn't "reliably identify" or "prick" an economic bubble in a timely fashion, holding rates at ultralow levels for an extended period "encourages bubbles because it encourages debt over equity and consumption over savings."

With the economy likely to grow around 3% for 2010, and with the weak labor market seen as stabilizing, the Fed could initiate an increase in key rates to 1%, ending the "borrowing subsidy" more quickly, and moderating credit conditions, he said.

Raising key rates also would lessen the chance of inflation, though Hoenig said inflation would likely remain low for the next year or two.

"Under this policy course, the FOMC would initiate some time soon the process of raising the federal-funds rate target toward 1%," Hoenig said. "I would view a move to 1% as simply a continuation of our strategy to remove measures that were originally implemented in response to the intensification of the financial crisis."

In order for the Fed to conduct effective monetary policy, Hoenig said it must continue to regulate both the largest U.S. banks and also smaller ones. If the Fed were stripped of its power to regulate all but the very biggest banks, Hoenig said there would no longer be any banks in his district big enough to be overseen by the Fed, limiting his access to assess economic conditions--key to setting effective monetary policy, he said.

Hoenig said the prospect of "too big to fail" for the biggest U.S. banks also was unfair to smaller institutions. Big banks should be treated the same as small banks, he said.

Hoenig also said he was a "very strong" supporter of the Volcker Rule, referring to former Fed Chairman Paul Volcker, who has called for a separation of commercial banking from proprietary-trading and hedge-fund activity.

With commercial banking and proprietary trading lumped into one, banks are effectively gambling money that is backed by the U.S., with the FDIC and other regulators responsible for backstopping losses, but banks taking all the gains, Hoenig said.

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