UPDATE 1-Macy's to have FAO Schwarz boutiques in stores

(Updates with confirmation, CEO comment)

NEW YORK, May 16 (Reuters) - Macy's Inc (M.N: Quote, Profile, Research, Stock Buzz) and FAO Schwarz said on Friday they signed an agreement under which the specialty U.S. toy retailer's toy stores will be opened in about 685 Macy's locations over the next two years.

Up to 275 Macy's stores will have FAO Schwarz-operated toy stores in fall 2008, the companies said, in time for the key holiday shopping season.

Terry Lundgren, Macy's Chief Executive said the deal with FAO Schwarz would "drive store traffic, particularly to our children's departments."

U.S. shoppers have faced rising gas prices and a housing market downturn have become hesitant with their spending and are cutting down on mall trips and purchases of items like clothes and furniture.

This autumn, FAO Schwarz shops at a size of between 1,000 square feet and 3,500 square feet will be launched at 75 Macy's stores across the United States, the companies said.

About 200 of the department store operator's locations will have smaller FAO Schwarz toy departments, at a size of 200 to 300 square feet. The new boutiques will carry the toy retailer's private label toys and other select brands, the companies said in a statement.

The companies also plan for FAO Schwarz products to be sold on Macy's Web site. (Reporting by Aarthi Sivaraman; Editing by Andrew Callus and Derek Caney)