-- Williams says Fed needs to remain stimulative

-- Williams cautions that 'substantial risks' remain

-- Williams says Europe remains a drag on U.S. economy

(Updates to include discussion of inflation targets in paragraphs 7-9. Changes dateline to Dana Point, Calif.)

By Matthew Walter and Andrew Morse

Of Dow Jones NEWSWIRES

DANA POINT, Calif. -(Dow Jones)- The U.S. economy remains fragile, which will require the Federal Reserve to maintain a stimulative monetary policy in the coming years to reduce unemployment and shield against the effects of Europe's financial turmoil, a top U.S. central banker said Friday.

While there are promising signs the U.S. recovery is becoming self-sustaining, inflation remains contained and it is still too early for policy makers to begin considering an interest-rate increase, said John Williams, president of the Federal Reserve Bank of San Francisco, in a planned speech.

"We're making progress on the employment part of our mandate, but we have a long way to go," Williams said in the speech to the California Bankers Association's annual convention. "Substantial risks remain that could cause the economy to perform worse than I expect. Under these circumstances, it's crucial that we continue our highly accommodative monetary policy."

Williams highlighted the somewhat-mixed economic picture Fed policy makers face, with consumer confidence, spending and manufacturing on the mend, even as unemployment remains too high. Williams is a voting member of the Federal Open Market Committee, and has been a consistent advocate of aggressive policies to boost employment, but the Fed last month revealed several central bank officials have showed a diminished interest in keeping rates low.

U.S. job growth slowed again in April and more Americans dropped out of the work force, with nonfarm payrolls increasing by a lower-than-expected 115,000 jobs, the Labor Department said Friday. The unemployment rate ticked down a tenth of a percentage point to 8.1%.

"The expansion has lacked the vigor of many past recoveries," Williams said Friday.

In response to an audience question, Williams said the idea of the Fed boosting inflation above the central bank's target rate of 2% to prompt consumer spending would have limited impact.

"The benefits would be modest," Williams told the audience. "The costs would be significant."

Williams also said inflation in fuel costs would likely subside, one of the reasons he sees inflation remaining tame.

And he pointed to risks posed by the European financial crisis, which he said would likely cut into demand for U.S. exports for years, and potential obstacles from spending cuts and tax increases in the U.S. scheduled to take effect at the end of this year.

"These risks weigh on the economy even if the worst doesn't happen," Williams said.

The San Francisco Fed chief expects the U.S. economy to expand 2.5% this year and 2.75% in 2013, with the unemployment rate holding around 8% through the end of the year and edging slightly lower next year.

Inflation should be close to the Fed's 2% target for 2012, and "somewhat below that" for the next two years, he said.

-By Matthew Walter and Andrew Morse, Dow Jones Newswires; 212-416-2910; matt.walter@dowjones.com