Jan. 4 (Bloomberg) -- Federal Reserve Bank of Chicago President Charles Evans supported plans for large U.S. fiscal stimulus while saying such policy is “sobering” because of “significant stress” confronting the federal balance sheet.

“By historical standards, our current fiscal debt is not unusually large,” Evans said yesterday in a speech in San Francisco. “But our expected future obligations are enormous.”

President-elect Barack Obama is working on a stimulus package of tax cuts and spending on roads, bridges and other infrastructure to create or save 3 million jobs. His advisers and congressional Democrats say the plan may total $850 billion, while economists and a group of Democratic governors led by New Jersey’s Jon Corzine have called for a $1 trillion outlay.

Recent economic data shows U.S. consumer confidence sinking to the lowest level in at least 41 years, home prices in 20 major cities falling at the fastest rate on record and a decline in U.S. manufacturing deepening.

“I believe a big stimulus is appropriate,” Evans, 50, said during the annual meeting of the Allied Social Science Associations. “But it is also sobering to be deploying large amounts of taxpayer funds at a time when our fiscal balance sheet is already coming under significant stress,” he said, adding that “the federal debt held by the public is 38 percent” of gross domestic product.

Last month, Fed policy makers cut the federal funds rate, or the interest rate banks charge one another for overnight loans, to as low as zero for the first time in an effort to end the longest economic slump in a quarter-century.

Growing Appetite

Treasury 10-year notes and 30-year bonds fell last week by the most in three months as stocks and the dollar rose, signifying a growing appetite for risk among investors.

Yields increased as the gap between what the government and banks pay to borrow money for three months, a gauge of banks’ reluctance to lend known as the TED spread, shrank to the narrowest since before Lehman Brothers Holdings Inc. collapsed. Rates on three- and one-month bills rose the most since October.

Stocks soared, and the dollar strengthened last week versus the yen. The dollar has gained 5.4 percent against the yen since Dec. 17, when the U.S. currency hit an almost-13-year low. It appreciated 24 percent against the greenback since credit markets began seizing up in August 2007 as investors shed bets on risky assets financed by low-interest loans denominated in Japan’s currency.

‘Two-Headed Dragon’

The central bank confronts a “two-headed dragon” of deflation and a return of 1970s-style inflation, St. Louis Fed President James Bullard said yesterday during a panel discussion sponsored by the National Association for Business Economics in San Francisco. “We’re not in a deflationary environment yet,” though “longer-run deflation could become a reality.”

The Fed shifted its focus last month to the amount and type of debt it buys, with a senior official saying that announcements of new lending programs or asset purchases will now be principal signals of policy.

One of the challenges confronting policy makers is “calibrating these unfamiliar policies and, in the future, determining the appropriate time and methods for winding them down,” Evans said.

“Policy makers face another very important challenge,” he said. “In a complex and dynamic environment, the public needs effective and transparent communications. As our lending facilities and other policy responses continue to evolve, this is a daunting task.”

“Undoubtedly, the greatest challenge we face is the enormous uncertainty of the situation,” he said.

Sentiment Index

The Conference Board’s sentiment index unexpectedly fell to 38, the lowest reading since records began in 1967, the New York- based private research group said Dec. 30.

The S&P/Case-Shiller index of home prices declined 18 percent in the 12 months to October after dropping 17.4 percent in September. The gauge has fallen every month since January 2007.

The Institute for Supply Management’s factory index fell to 32.4, the lowest level since 1980. Readings less than 50 signal contraction.

Evans took office in September 2007, replacing Michael Moskow. Evans, a former director of research and senior vice president at the bank, is set to vote on interest rates this year.

He said the Fed should concentrate on designing regulatory policies “aimed at helping to prevent and protect against the consequences of asset price bubbles.” At the same time, such an aggressive campaign might “entail large downside costs if the assessment proves to be wrong,” Evans said.

To contact the reporter on this story: Vivien Lou Chen in San Francisco at vchen1@bloomberg.net

Last Updated: January 4, 2009 16:00 EST