Fed to dampen rate hike talk, halt Treasury buying

By Alister Bull

WASHINGTON (Reuters) - The Federal Reserve meets this week with the delicate task of curbing a surge in expectations that it is ready to starting raising interest rates, without snuffing out crucial optimism on the economy.

Policy-makers are also likely to allow a controversial scheme to buy $300 billion of longer-dated Treasuries to end on schedule in September. But they may discuss extending a separate program to support the flow of credit to consumers and business, with an eye on propping up commercial real estate.

The policy-setting Federal Open Market Committee (FOMC) will meet on Tuesday and Wednesday, and central bankers are expected to hold the overnight fed funds rate in a range between zero and 0.25 percent. A statement on their decision is due after 2:15 p.m. on Wednesday.

A much better-than-expected July U.S. employment report boosted investor speculation on Friday that the Fed would begin to tighten monetary policy early next year, but economists said this judgment was very premature.

"The markets have begun pricing in a near-term increase in interest rates. That is extremely unlikely. The Fed is going to want to discourage that," said former Fed Board Governor Lyle Gramley. He said the policy statement may emphasize the lower risk of inflation to indicate that no rate hikes were on the horizon.

U.S. employers cut 247,000 jobs in July, far below forecast cuts, while the unemployment rate inched down to 9.4 percent from 9.5 percent the month before. The news chimed with other signals that economic activity was stabilizing and the worst recession since the Great Depression was coming to an end.

PREMATURE

Following the report, interest rate futures reflected increased expectations that the Fed will raise interest rates, with a hike to 0.50 percent by February fully priced into markets, and 1.0 percent seen in May.

This view contrasts starkly with recent remarks from officials, including Fed Chairman Ben Bernanke in testimony to Congress on July 22, that have emphasized that the U.S. economy remains fragile and the Fed is in no hurry to begin raising rates.

If markets take a different view and start factoring in higher Fed interest rates than previously anticipated, this could translate into a spike in bond yields that would push up all borrowing costs and potentially undermine the recovery.

As a result, policy-makers are expected to acknowledge that the pace of economic contraction has slowed since their meeting in June, while nodding to the somewhat brighter outlook. But they will reiterate their view that economic conditions will warrant exceptionally low interest rates for a time to come.

"Even though the post-meeting policy statement is likely to incorporate a more upbeat tone on the economy, the FOMC should reaffirm their commitment to maintaining a zero-25 basis point funds rate target for an extended period," Mizuho Securities' chief economist Steven Ricchiuto wrote in a note to clients.

With no change to rates expected, the most likely action next week will be an announcement that the Fed will allow its program to buy up to $300 billion of longer dated U.S. government bonds to expire on schedule in September.

The campaign, which is in addition to Fed purchases of $1.45 trillion of mortgage debt by the end of the year, quickly become a lightning rod for concerns about future inflation and criticism that the central bank was helping to finance a record U.S. budget deficit, also called monetizing the debt.

"I don't think there is any likelihood it is going to be continued," said Gramley. "With continued worries in markets that at some point the Fed will have to monetize the debt, it is better to not be seen as buying longer term Treasuries under these circumstances," he said.