FED FOCUS-Fed seen extending, not increasing Treasury buys

WASHINGTON, June 16 Tue Jun 16, 2009 1:56pm EDT

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WASHINGTON, June 16 (Reuters) - The Federal Reserve may extend its purchases of U.S. Treasuries when it meets next week to keep juicing the economy, but an aggressive expansion of buying is not likely given inflation concerns.

A steep rise in U.S. government bond yields has spilled over into mortgage rates. That could sap an economic recovery expected to get under way in the next few months.

But other measures of credit market strain, like the spread between U.S. government debt and recent corporate debt issues, have eased. So the overall impact of rising yields may not be that dire, easing pressure for dramatic Fed action.

"I don't think they can afford to go out and aggressively buy longer-term Treasuries or even step-up aggressively their purchases of mortgage debt," said former Fed Governor Lyle Gramley, referring to a powerful $1.75 trillion package of Fed asset purchases designed to spur economic growth.

"There is this fear going around in financial markets that the Fed is going to monetize the debt, and we're going to have big inflation. I don't believe that for a minute, but the perception is a reality that the Fed is going to have to deal with," Gramley said.

Monetizing the debt, as opposed to asset purchases rooted in monetary policy, refers to Fed buying of government bonds to sop up debt issued by the Treasury to finance a record U.S. budget deficit.

This amounts to the Fed effectively printing money and will ultimately trigger serious inflation if these additions to the money supply are left sloshing around the economy too long.

SPLIT VIEWS

Some Fed officials are troubled by perceptions of the Fed monetizing the debt. They also see a risk of an upward creep in inflation expectations that they do not want to ignore.

These officials don't think the Fed has to begin tightening policy at its June 23-24 meeting, or at the subsequent one on August 11-12.

But they also do not see a need to maintain the current pace of monetary expansion, despite small recent declines in the size of the Fed's balance sheet.

The balance sheet shrank by around $25 billion in the week to June 10. But this reflected what could be described as healthy, voluntary pay-downs of the Fed's commercial paper support facility, as well as swap lines providing dollars to other central banks.

These Fed officials want to start moving toward an exit strategy from the central bank's massive policy stimulus. This has doubled its balance sheet to $2 trillion, and they don't want to make their task harder by adding to its size.

"The Fed will have to change policy well in advance of clear evidence of actual inflation having taken hold if it is to be successful in containing inflation," Robert Eisenbeis, chief monetary economist at Cumberland Advisors, wrote in a note to clients.

Other Fed officials who spoke to Reuters worry that the U.S. economy remains very vulnerable. They view mounting optimism over the recovery, and an accompanying anticipation of early Fed interest rate hikes from almost zero, as premature.

As a result, these officials feel that failing to extend Treasury purchases beyond the current end-date of late September could amount to an effective Fed policy tightening, and they want to avoid ending the central bank's monetary stimulus too soon.

DISSENT AND COMPROMISE

The debate is going to strain unity among policy-makers and risks one or more dissents at their policy meeting next week.

But on balance, Fed-watchers say that there is probably enough shared concern about the economy among policy-makers to forge a compromise that extends Treasury purchases until the end of the year, if not actually ramping up the scale of buying beyond an already-announced $300 billion.

In addition to these purchase, the Fed has also committed to buying $1.45 trillion in mortgage-related debt.

"It seems to me the moment has shifted away from those who saw the clear need for more aggressive policy ... to a 'stay the course'," said former Fed Governor Laurence Meyer of Macroeconomic Advisers.

A key theme for the meeting next week is the diagnosis of the steepening in the yield curve, measured by the gap between 2- and 10-year government bonds, which recently reached a record 2.75 percentage points.

If bond yields are up due to technical factors, such as mortgage securities-related hedging, then the Fed may see expanded Treasury purchases as warranted.

But if bond yields have risen because greater optimism over the economy has reduced bids for bonds as a safe haven -- and that is the prime suspect -- that suggests the Fed may not need to spur growth by pushing down rates, and would have a hard time trying.

Richmond Federal Reserve President Jeffrey Lacker and Atalanta Fed chief Dennis Lockhart both separately said last week that the most likely reason for higher yields was the recent spate of better-than-expected economic indicators.

These have contributed to a sense the Fed may raise interest rates sooner than had been anticipated, and as the market factors this back into the term-structure of market interest rates, bond yields have risen accordingly.

Concerns over inflation, and Fed purchases of government debt, may also have played a role in pushing up risk premiums, and that too could dissuade the Fed from a more aggressive program.

But as Dallas Fed President Richard Fisher noted on Monday, both spreads and outright rates on corporate debt have managed to decline, despite the yield curve shift, indicating that the asset purchase program had succeeded in easing strains.

"The implications of this run-up in long-term Treasury interest rates has not been as dire as one might have anticipated," said Gramley, pointing to both the narrower borrowing spreads and buoyant stock markets. "I don't think it has changed the outlook very much and I don't think they'll fret and stew about it." (Editing by Andrea Ricci)

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