Sept. 11 (Bloomberg) -- Stanford University professor John Taylor said the U.S. Federal Reserve may have to start raising interest rates at the start of 2010 to contain price pressures.

“If inflation starts to pick up” as the economy recovers, “the Fed’s going to have to raise rates as early as the first part of next year,” Taylor said in an interview on Bloomberg Television in New York today.

The Fed has kept its interest rate in a target range of zero to 0.25 percent since December in a bid to pull the economy out of a recession. The central bank has switched to asset purchases and credit programs as its main policy tools.

Under Chairman Ben S. Bernanke, the Fed used emergency powers to rescue American International Group Inc., as well as markets for commercial paper, housing bonds and asset-backed securities. In the process, the Fed’s balance sheet expanded by $1.2 trillion over the past year.

Treasury Secretary Timothy Geithner said yesterday that the government is moving to withdraw some of its support for financial markets.

“He’s right to be pointing out that it’s time to be thinking about it,” Taylor said today. “The Fed’s balance sheet has just exploded. They’ve got to find a way to bring it down.”

The U.S. this quarter will emerge from the worst recession since the 1930s, economists say. The economy will grow at a 2.9 percent annual rate from July through September, according to the median of 61 estimates in a monthly Bloomberg News survey.

Budget Deficit

In an interview on Bloomberg Radio today, Taylor said the $787 billion stimulus package will add to the federal budget deficit and called that “potentially inflationary.” The budget shortfall will probably total $1.6 trillion this year, according to the Congressional Budget Office.

Of the stimulus plan, Taylor said “we don’t see it having much impact yet.” He said that in California, only $10 million of $3.5 billion for infrastructure projects has been paid out.

The White House yesterday said that the stimulus program has created or saved as many as 1.1 million jobs since its implementation in February.

The Obama administration, in its first quarterly report to lawmakers in Washington on the economic impact of the program, said it added 2.3 percentage points to gross domestic product in the second quarter. It will likely add another 3 percentage points to growth from July through September, the White House said.

Taylor, 62, a Stanford University professor, devised the “Taylor Rule,” a formula for rate-setting based on the outlook for inflation and growth. He worked for the administration of President George W. Bush in the Treasury Department as undersecretary for international affairs from 2001 to 2005.

Taylor has said that he’s concerned the Fed’s emergency loans will draw the central bank into allocating credit to politically favored industries, such as housing. Taylor calls such actions by the monetary authority “mondustrial policy.”

Taylor and former Fed Vice-Chairman Alan Blinder are among economists who say low borrowing costs under Chairman Alan Greenspan encouraged the easy credit that fostered the housing bubble.

To contact the reporters on this story: Svenja O’Donnell in London at sodonnell@bloomberg.net; Erik Schatzker in New York at eschatzker@bloomberg.net.

Last Updated: September 11, 2009 09:01 EDT