| WASHINGTON, June 16
WASHINGTON, June 16 The Federal Reserve may
extend its purchases of U.S. Treasuries when it meets next week
to keep juicing the economy, but an aggressive expansion of
buying is not likely given inflation concerns.
A steep rise in U.S. government bond yields has spilled
over into mortgage rates. That could sap an economic recovery
expected to get under way in the next few months.
But other measures of credit market strain, like the spread
between U.S. government debt and recent corporate debt issues,
have eased. So the overall impact of rising yields may not be
that dire, easing pressure for dramatic Fed action.
"I don't think they can afford to go out and aggressively
buy longer-term Treasuries or even step-up aggressively their
purchases of mortgage debt," said former Fed Governor Lyle
Gramley, referring to a powerful $1.75 trillion package of Fed
asset purchases designed to spur economic growth.
"There is this fear going around in financial markets that
the Fed is going to monetize the debt, and we're going to have
big inflation. I don't believe that for a minute, but the
perception is a reality that the Fed is going to have to deal
with," Gramley said.
Monetizing the debt, as opposed to asset purchases rooted
in monetary policy, refers to Fed buying of government bonds to
sop up debt issued by the Treasury to finance a record U.S.
This amounts to the Fed effectively printing money and will
ultimately trigger serious inflation if these additions to the
money supply are left sloshing around the economy too long.
Some Fed officials are troubled by perceptions of the Fed
monetizing the debt. They also see a risk of an upward creep in
inflation expectations that they do not want to ignore.
These officials don't think the Fed has to begin tightening
policy at its June 23-24 meeting, or at the subsequent one on
But they also do not see a need to maintain the current
pace of monetary expansion, despite small recent declines in
the size of the Fed's balance sheet.
The balance sheet shrank by around $25 billion in the week
to June 10. But this reflected what could be described as
healthy, voluntary pay-downs of the Fed's commercial paper
support facility, as well as swap lines providing dollars to
other central banks.
These Fed officials want to start moving toward an exit
strategy from the central bank's massive policy stimulus. This
has doubled its balance sheet to $2 trillion, and they don't
want to make their task harder by adding to its size.
"The Fed will have to change policy well in advance of
clear evidence of actual inflation having taken hold if it is
to be successful in containing inflation," Robert Eisenbeis,
chief monetary economist at Cumberland Advisors, wrote in a
note to clients.
Other Fed officials who spoke to Reuters worry that the
U.S. economy remains very vulnerable. They view mounting
optimism over the recovery, and an accompanying anticipation of
early Fed interest rate hikes from almost zero, as premature.
As a result, these officials feel that failing to extend
Treasury purchases beyond the current end-date of late
September could amount to an effective Fed policy tightening,
and they want to avoid ending the central bank's monetary
stimulus too soon.
DISSENT AND COMPROMISE
The debate is going to strain unity among policy-makers and
risks one or more dissents at their policy meeting next week.
But on balance, Fed-watchers say that there is probably
enough shared concern about the economy among policy-makers to
forge a compromise that extends Treasury purchases until the
end of the year, if not actually ramping up the scale of buying
beyond an already-announced $300 billion.
In addition to these purchase, the Fed has also committed
to buying $1.45 trillion in mortgage-related debt.
"It seems to me the moment has shifted away from those who
saw the clear need for more aggressive policy ... to a 'stay
the course'," said former Fed Governor Laurence Meyer of
A key theme for the meeting next week is the diagnosis of
the steepening in the yield curve, measured by the gap between
2- and 10-year government bonds, which recently reached a
record 2.75 percentage points.
If bond yields are up due to technical factors, such as
mortgage securities-related hedging, then the Fed may see
expanded Treasury purchases as warranted.
But if bond yields have risen because greater optimism over
the economy has reduced bids for bonds as a safe haven -- and
that is the prime suspect -- that suggests the Fed may not need
to spur growth by pushing down rates, and would have a hard
Richmond Federal Reserve President Jeffrey Lacker and
Atalanta Fed chief Dennis Lockhart both separately said last
week that the most likely reason for higher yields was the
recent spate of better-than-expected economic indicators.
These have contributed to a sense the Fed may raise
interest rates sooner than had been anticipated, and as the
market factors this back into the term-structure of market
interest rates, bond yields have risen accordingly.
Concerns over inflation, and Fed purchases of government
debt, may also have played a role in pushing up risk premiums,
and that too could dissuade the Fed from a more aggressive
But as Dallas Fed President Richard Fisher noted on Monday,
both spreads and outright rates on corporate debt have managed
to decline, despite the yield curve shift, indicating that the
asset purchase program had succeeded in easing strains.
"The implications of this run-up in long-term Treasury
interest rates has not been as dire as one might have
anticipated," said Gramley, pointing to both the narrower
borrowing spreads and buoyant stock markets. "I don't think it
has changed the outlook very much and I don't think they'll
fret and stew about it."
(Editing by Andrea Ricci)