UPDATE 1-FED FOCUS-Pitfalls lurk as Fed marches toward transparency
* Fed officials eye economic thresholds as policy guide
* Thresholds would signal when rate-hike decision nearing
* Trick is getting hair-trigger markets to behave
NEW YORK, Nov 20 (Reuters) - Federal Reserve officials want to tell the world what would cause them finally to reverse four years of easy U.S. monetary policy, but something is keeping them up at night.
In the central bank's nightmare scenario, anxious investors drive up Treasury yields and abandon stocks as the nation's unemployment rate edges toward a level officials had flagged as a goal, effectively tightening financial conditions and undermining monetary policy before the Fed was ready to act.
The worry is that such a situation could trip up the slow recovery from the Great Recession just when the U.S. economy finally gains pace. The Fed is carefully plotting how to avoid this communications nightmare.
These worries are slowing progress toward an agreement among the Fed's 19 policymakers on so-called thresholds - economic data points, like specific unemployment and inflation rates - that would signal when the central bank is likely to begin raising benchmark interest rates from near zero.
Many of the officials want to adopt them and influential Fed Vice Chair Janet Yellen voiced her strong support last week, making the project sound all but inevitable.
In his most detailed public comments on the growing debate, Bernanke on Tuesday called the thresholds "a very promising direction" for policy because it would help markets predict future Fed decisions. But it would be a challenge to summarize into "two or three numbers" the conditions necessary for the Fed to tighten policy, he cautioned.
Such a rule would probably hinge on several pieces of economic information, such as the number of Americans hunting for work. If adopted, the rule would be the latest step toward Bernanke's goal of a more transparent central bank.
But the trick is getting a hair-trigger market to behave.
Although the Fed's aim would be to inform the market how long its ultra-easy policies will stand, that could backfire if investors interpret the conditional thresholds as automatic triggers, or if they try to front-run tighter policies.
"Aggressive traders are all for the Fed going in that direction because it will put money in their pocket," said Brian Reynolds, chief market strategist at New York brokerage Rosenblatt Securities.
"If you give them some concrete rules laid out in advance, the hedge funds will beat the Fed to the punch," he said.
To be sure, investors have long tried to predict changes to monetary policy. Indeed, markets need to react for those policies to work effectively. But as the Fed tests new ways to explain its unprecedented easing, it might court trouble if communications rules are too precise.
Fed officials are well aware of this threat, setting the stage for a delicate few months of trying to persuade investors that whatever rule they adopt is credible and helpful, but not set in stone.
They could also abandon the idea altogether.
PROCEED WITH CAUTION
Thresholds would replace a pledge the central bank has made to keep rates low until mid-2015. Many Fed officials and outside economists do not like this "calendar date" because it seems rigid or far-fetched and can be misinterpreted as a promise.
Hinting at the challenges ahead, Yellen, who chairs a Fed subcommittee on communications and is a front-runner to succeed Bernanke in 2014, stressed last week that the thresholds would not trigger a rate hike. She also said that decision would require further deliberation by policymakers.
But not everyone is convinced the message will get through.
Philadelphia Fed President Charles Plosser, who sits on Yellen's subcommittee, said thresholds could be misinterpreted as longer-run policy goals. "I am concerned that we would create more confusion than clarity," he said on Thursday.
Plosser voiced similar concerns back in January, when the Fed's latest change in communications confused some investors.
Emerging from a policy-setting meeting, the Fed announced it intended to keep rates low until late 2014 and then, hours later, published for the first time charts showing that more than a third of its policymakers expected a rate rise before 2014.
The contradicting messages whiplashed bond markets and may have instilled some extra caution in the central bank as it looks forward to yet new ways to refine communications.
U.S. unemployment was lofty at 7.9 percent last month, while inflation has remained a bit below the Fed's 2 percent target.
Many factors, from wages to demographics to government spending, are behind the unemployment rate. The inflation rate is similarly "noisy," which poses problems if the thresholds are interpreted as blunt tools.
For example, the Fed is not likely to be satisfied with a jobless rate that is dropping because Americans are leaving the workforce en masse, as has sometimes been the case over the last 18 months.
But these important nuances may not matter to investors who anticipate the Fed will keep its word and move to raise short-term interest rates when the threshold nears.
"The market will start pricing in a lot of hikes, then the yield curve will steepen quite a bit, and equities will tank, and a lot of the good things that had momentum going into that move could become undone," predicted Krishna Kumar, a partner at New York hedge fund Goose Hollow Alpha Advisors.
"It becomes an expectations game," he added.
At the last few Fed meetings, talk of thresholds has heated up.
Last month, officials weighed the merits of adopting quantitative thresholds versus a more qualitative description of what informs its thinking, according to the Fed's minutes. In the end, "a number of practical issues" were left unresolved, and Bernanke told staff to do more work on the proposal.
The careful internal deliberations have not stopped some central bank policymakers from taking their ideas on the road.
Last year, Chicago Fed President Charles Evans pitched thresholds of 7 percent unemployment and no more than 3 percent inflation. In the last few months, two other regional Fed presidents floated their own plans.
Bernanke is set to hold a press conference after the Fed's Dec. 11-12 policy meeting, but that might be too early for any final decision.
"We are probably still a couple of months away from such a communication strategy," said Michael Feroli, chief U.S. economist at JPMorgan. In the meantime, he said, the Fed will probably continue educating the market on how to interpret the thresholds.
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