UPDATE 2-Volcker-Fed must not sow seeds of inflation

Thu Sep 23, 2010 4:23pm EDT

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(Adds background on Volcker's, Bernanke's rate policies)

By Ann Saphir

CHICAGO, Sept 23 (Reuters) - Paul Volcker, special adviser to U.S. President Barack Obama, said on Thursday that while the Federal Reserve's purchases of long-term Treasuries are "understandable," the U.S. central bank must be careful not to set the stage for future inflation.

The former Federal Reserve chairman, known for slaying inflation in the 1980s by hiking interest rates well into the double digits, said he is not worried about deflation, and that he believes the country is on the road to price stability.

"We are in a situation now where we've got a sluggish economy, a lot of excess resources, a lot of unemployment -- this is not an atmosphere that's inclined to produce inflation," he told reporters on the sidelines of a banking conference at the Chicago Fed.

"I think we ought to be sure that we don't take actions that down the road might lead to an inflationary situation."

Volcker's super-high interest rate policy earned him vociferous criticism from some quarters, a token of which Chicago Fed President Charles Evans held aloft as he introduced Volcker -- a two-by-four wood block famously sent to the Fed chairman by angry homebuilders who viewed high rates as bad for business.

Today, Fed Chairman Ben Bernanke is taking an exact opposite approach against a vastly different backdrop, using super low rates and asset purchases in what some view as an attempt to push up uncomfortably low inflation.

The Fed lowered its target rate for overnight lending between banks to near zero in December 2008 to help pull the nation from its deepest recession since the 1930s, and has since bought about $1.7 trillion in long-term Treasuries and mortgage-backed securities to further spur the economy.

But with unemployment at a lofty 9.6 percent and amid signs that the economic recovery may be faltering, Fed officials are now debating whether to embark on a new round of monetary easing through the purchases of more Treasuries.

Indeed, some market participants believe the Fed's decision last month to reinvest the proceeds of maturing mortgage-backed bonds on its books in long-term Treasuries, keeping its nearly $2 trillion balance sheet steady instead, signaled outright purchases ahead.

Earlier this week, Fed policymakers left their current policies intact, but said they were ready to act if needed.

Despite his concerns about potential future inflation, Volcker said he was not concerned by the Fed's decision to buy long-term Treasuries to bolster the economy.

When he joined the U.S. central bank in the 1950s, the Fed routinely bought and sold bonds to influence the market, Volcker told attendees at the banking conference.

While later the Fed came to the view that it should only intervene in the short-term money markets, he said, buying longer-term securities does not violate any rules.

"Given present conditions, I don't feel this violates some Fed doctrine or ethics or whatever," Volcker said. (Reporting by Ann Saphir; Editing by Dan Grebler)

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