How the Fed will weigh up Treasuries buying

WASHINGTON (Reuters) - The U.S. Federal Reserve's meeting next Tuesday and Wednesday is likely to be dominated by what to do about its controversial program to buy longer-dated U.S. government bonds.

They can extend the $300 billion commitment, increase it, or allow it to expire on schedule later next month.

So far, the Fed has bought $243 billion under the program and at the current pace of weekly purchases the money will run out by the end of September. It is also buying up to $1.45 trillion of mortgage debt by the end of 2009.

Economists think that there are good reasons to expect the Fed to let the Treasury purchase program come to an end, at least for now. These are some of the pros and cons that policymakers will weigh:

STOCKS VERSUS FLOWS

The argument to extend the program is cast in several ways, but boils down to whether policymakers think that the biggest impact from the program was gained from announcing the Fed would buy $300 billion worth of government bonds, which is the so-called stock argument, or whether the regular purchases help support the market, which is the flow argument.

Some theoretical work on this was done by Fed economists in 2000, when large budget surpluses led to projections that the Treasury market would shrink and the share of it owned by the U.S. central bank correspondingly increase.

Efficient market theory suggests that most of the impact is felt by the announcement of the purchase because investors very quickly discount the impact, making when the purchases are subsequently made much less important.

An exception to this was felt to be when the market was segmented or somewhat dysfunctional, or where the Fed had a major share or even a monopoly in a particular security, and then the timing of purchases could make a difference.

If policymakers think the stock argument prevails, then the Fed has already gleaned most of the benefits up front and allowing it to come to a halt will not be a problem.

If policymakers come down on the side of the flow argument, then they may worry that ending the purchases could be disruptive to the Treasury market, removing a source of demand that could push prices lower and yields higher.

This might be a case to extend the program and maybe make it a bit bigger in order to give markets time to get used to the purchases winding down.

DEFACTO TIGHTENING

Policymakers will also consider the broader macroeconomic implications of letting the program come to a halt.

The asset purchases have allowed the Fed to boost the size of its balance sheet and lean against a collapse in the U.S. monetary base when credit markets froze in shock following the failure of investment bank Lehman Brothers in September.

Allowing the Treasury purchase program to expire may lead to an unwelcome decline in the size of the balance sheet at a time when the economy is still fragile. Some people may view this as a defacto tightening of monetary policy.

But policymakers who think the stock argument is more important will tend to disregard this threat, on the basis that additional buying on the relatively modest scale that has been announced won't make much difference.

PREMATURE EXIT

That said, the Fed is definitely very wary of signaling that it is anywhere close to exiting from extraordinary measures to end the recession that doubled its balance sheet to around $2 trillion.

Unemployment is very high. It dipped to 9.4 percent in July from 9.5 percent previous month, but most economists inside and outside the Fed think it will climb higher, even as other data indicates a gradual recovery is on track for the rest of 2009.

Also, policymakers worry about another dip in activity once short-term stimulus measures fade later this year and do not prematurely want to withdraw their easy monetary policy.

YIELD CURVE

It matters what investors think the Fed will do in the future because if investors anticipate higher overnight fed interest rates, these will quickly get priced into higher yields on longer dated bonds as well. This could prematurely drive up borrowing costs and potentially sap the recovery.

The Fed is keen to avoid this unwelcome steepening in the yield curve, so the argument about unintentionally semaphoring a step toward the policy exit will have to be debated seriously by members of the Federal Open Market Committee.

But some Fed officials, including Chairman Ben Bernanke, have gone out of their way to stress that the link between the size of their balance sheet and monetary conditions in the economy has been broken by their ability, since last year, to pay interest on excess reserves held by banks at the Fed.

They say the Fed can tighten monetary policy to keep inflation under wraps when the time is right, despite the bloated size of its balance sheet.

NOT QE

Economists think that this attitude also extends to a skeptical appraisal at the top of the Fed of the benefits of using Treasury purchases as a tool of quantitative easing (QE) to stimulate economic activity.

In fact, minutes of the Fed's June meeting showed that policymakers were uncertain of the impact of expanding Treasury purchases on either the economy or inflation expectations, owing to claims it was monetizing the debt.

This criticism, stoutly denied by the Fed, links its buying of government bonds to the need of the government to finance a record budget deficit and higher long-term inflation.

However, it is not something the Fed can afford to ignore, and the negative reaction of investors could undermine support for the buying at a time when indicators anyway signal that the economy does not need additional policy stimulus.

A Reuters poll found 14 of the 16 dealers surveyed do not expect the Fed will increase the program beyond $300 billion.

(Reporting by Alister Bull; Editing by Kenneth Barry)