By David Milliken

"Although we have seen signs of improvement, financial market functioning remains impaired in many ways, and we will need to continue to consider whether additional steps are needed to reopen credit flows and support the economy," Kohn said at a Banque Centrale du Luxembourg event in Luxembourg.

When financial markets stabilize and economies start to recover, central banks will need to decide how to phase out extraordinary provisions of liquidity and other credit-market interventions, he said.

In the meantime, some tools created to combat the crisis may become a permanent part of central bank instruments, Kohn said. These include currency swaps between central banks and the Fed's auctions of discount window credit, he said.

The U.S. central bank has slashed rates by 4.25 percentage points since September 2007 and launched a fleet of liquidity facilities aimed at restoring lending and shielding the economy from a deep and protracted recession.

The U.S. government has also stepped in to rescue major financial institutions, including investment bank Bear Stearns and insurer American International Group.

The financial crisis, which began with a spike in U.S. mortgage defaults but escalated into a broad lack of confidence in credit, has pummeled economies around the world.

Kohn said central banks' most immediate and important challenge is to help restore financial systems and put economies on paths to growth and price stability.

Policy-makers must adapt financial system rules to make sure the financial system can withstand even the occasional severe shock, he said.

Kohn acknowledged that central bank officials misjudged the impact of the financial sector on the broader economy, as asset prices inflated as well as after the bubble burst.

"We did not fully appreciate how financial innovation interacted with the channels of credit to affect real economic activity -- both as credit and activity expanded and as they have contracted," he said.

Policy-makers may need to reassess the long-held view of many that interest rates are too blunt a tool to prevent asset price bubbles from forming, Kohn said.

"Should the manipulation of short-term interest rates take account of the potential for imbalances and price bubbles as well as the traditional objectives of price stability and economic growth?" Kohn asked. "The lessons of the current episode need to be studied further."

(Writing by Mark Felsenthal in Washington; Editing by Leslie Adler)