FED FOCUS-Fed could aid fiscal stimulus with bond purchases

WASHINGTON (Reuters) - The Federal Reserve will likely be a willing buyer for the mountain of U.S. debt that will need to be issued to fund efforts that President-elect Barack Obama and Congress plan to pursue to stimulate the shrinking U.S. economy.

Fed Chairman Ben Bernanke has suggested the central bank is prepared to buy Treasuries as a way to hold interest rates down just as Congress and the Obama administration prepare to plow as much as a half-trillion dollars into the economy in an effort to reverse a recession.

"The Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities," Bernanke said on Monday as he laid out ways the central bank could spur borrowing even when its traditional tool of interest rates nears zero.

"This approach might influence the yields on these securities, thus helping to spur aggregate demand," he said.

The central bank chief observed that the Fed's recent decision to buy debt issued by mortgage finance providers Fannie Mae and Freddie Mac and mortgage-backed securities guaranteed by those firms had already helped to lower mortgage interest rates.

Obama, who takes office on January 20, said last week he wanted to move right away on a package of measures that was large enough to give the economy a "jolt."

A Democratic aide said the House of Representatives would pursue a bill costing about $500 billion that would include a tax cut for the middle class and infrastructure spending.

A WILLING BUYER

Such spending would further explode U.S. borrowing, which is already shooting higher to support a $700 billion financial bailout package at a time of shrinking tax revenues.

The huge increase in borrowing runs the risk of pushing up yields on Treasury debt -- which moves in the opposite direction to the price of those securities -- as the government seeks to attract buyers. And higher rates, particularly long-term borrowing costs that influence home mortgages, might chill economic activity rather than boost it.

"The Fed will do anything to keep the cost of borrowing low," Axel Merck, president of Merck Investments wrote in a note to clients.

The central bank's purchases of mortgage-backed securities and a separate Fed program that snaps up commercial paper that companies issue to fund day-to-day operations may now be followed by purchases of government debt to finance spending programs, he said.

Normally such a practice -- referred to as "monetizing the debt" -- could result in inflation.

But despite vast amounts of liquidity the Fed has pushed into the financial system, banks worried about their own finances and the credit-worthiness of would-be borrowers remain reluctant to lend.

That reluctance, and signs expectations of future inflation are not building up, have Fed officials convinced that they can focus on their efforts at turning back the recession. The trick will be gauging the timing of reversing course to soak up all the excess liquidity they are pumping into the economy.

THE ANTI-DEFLATION TOOLKIT

The Fed has already cut benchmark overnight interest rates to 1 percent to try to put a floor under the economy and financial markets are banking on rates hitting 0.5 percent at the end of a two-day Fed policy meeting on December 16. That would be the lowest on records dating to July 1954.

With little scope to chop rates further, officials are expected to discuss alternative policies to spur activity and head off the risk of a debilitating deflation, in which prices drop throughout the economy.

Bernanke's speech on Monday was seen as a road map for a route the central bank might take.

"Going forward, our nation's economic policy must vigorously address the substantial risks to financial stability and economic growth that we face," he said.

The Fed chairman, a scholar of the Great Depression, laid out a wider script for potential action in a speech in 2002.

"The effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities," he said then.

"A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices."

(Reporting by Mark Felsenthal, Editing by Chizu Nomiyama)