Fed says ready to buy debt to aid economy

By Mark Felsenthal

WASHINGTON (Reuters) - The Federal Reserve on Wednesday said it is prepared to buy long-term U.S. government debt if that would help improve credit conditions and signaled some concern that deflation risks were rising.

In a statement issued at the end of a two-day meeting, the central bank's policy-setting panel also said it was holding its target range for overnight interest rates at zero to 0.25 percent -- the level reached in December -- and repeated that it thought rates could stay unusually low for some time.

"The committee ... is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets," it said. In December, the Fed had said only that it was studying that option.

The panel voted 8-1 in support of the decision. Richmond Federal Reserve Bank President Jeffrey Lacker dissented, saying he thought the Fed should immediately move to a program to purchase government bonds.

U.S. government debt prices fell sharply, suggesting investors wanted a clearer sign the Fed would become a buyer of bonds. Stock prices added to gains .DJI and the dollar rose.

With benchmark overnight rates virtually at zero, the Fed has turned its focus to what Chairman Ben Bernanke has dubbed a "credit easing" approach that targets specific assets and markets in the hope of restoring normal lending.

"Basically they are opening their wallets and are ready to start buying more assets and extend that if necessary," said Kurt Karl, head of economic research at Swiss Re in New York.

The central bank is endeavoring to ensure a year-long recession does not lead to a prolonged period of falling prices that could further undermine activity.

"The committee continues to anticipate that a gradual recovery in economic activity will begin later this year, but the downside risks to that outlook are significant," it said.

It added that it "sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term" -- a nod to growing concern over the risk of deflation.

READY TO RAMP UP EMERGING PROGRAMS

The Fed said that if needed it would expand an existing program in which it is buying large quantities of mortgage-related debt, and reiterated that it was about to launch another program to shore up auto, credit card and small business lending.

The Fed's efforts are part of a broader government initiative to combat the recession and a financial crisis that has stalled economies around the globe.

The U.S. central bank has cut its key interest rate from 5.25 percent in 10 steps dating to September 2007 and has pumped billions of dollars into the economy to try to restore credit markets shattered by the bursting of a housing bubble and a wave of mortgage failures.

At the same time, President Barack Obama, who swept to victory in November in part because of the deepening economic gloom, is pushing for an $825 billion package of tax cuts and government spending. His administration is also wrestling with steps it can take to prop up the ailing banking system.