* Treasury takes action to stave off hitting debt limit
* Political battle intensifying over spending, borrowing
* U.S. budget position worsening after tax cut extension (recasts first paragraph, adds details, background)
By Glenn Somerville
WASHINGTON, Jan 27 (Reuters) - The U.S. Treasury on Thursday initiated the first in what is likely be a series of maneuvers aimed at preventing it from hitting a legal debt limit as a political battle over spending intensified.
The action to reduce the amount of money the Treasury holds in a special account at the Federal Reserve marked only a small step in freeing up new borrowing capacity, but was symbolically important as the Obama administration and Republican lawmakers stake out ground in a wider budget debate.
As of Tuesday, Treasury's remaining borrowing authority was down to $279 billion -- all that remained before it bumps against a legally set $14.294 trillion debt ceiling.
That is little more than a drop in the bucket for a government that relies on borrowing to finance day-to-day costs for everything from running the war in Afghanistan to cutting Social Security checks for retirees.
Treasury Secretary Timothy Geithner warned Congress earlier this month the debt limit could be reached as soon as March 31 or as late as May 16, depending on how the economy performs and how much flows into Treasury's coffers by an April 15 tax deadline.
'CATASTROPHE' ON HORIZON?
Failure to lift the ceiling could precipitate default and have "catastrophic" economic consequences, Geithner warned.
For a Factbox on further steps Treasury could take, see
For questions and answers on the debt limit, see
Treasury gained limited ground through Thursday's action, which officials said was already factored into Geithner's estimate of when the debt ceiling will be reached.
Beginning on Feb. 3, it will gradually cut the balance in the Supplementary Financing Program to $5 billion from $200 billion. It can do so by letting short-term bills that finance it mature and not issuing new ones.
Under the program, which was set up in September 2008 at the peak of the financial crisis, the Treasury sold short-term bills and turned the proceeds over to the Fed to help manage its balance sheet while the central bank propped up a faltering banking system.
Republicans are seeking to use the need to raise the nation's borrowing capacity as leverage to exact spending cuts from the Obama administration and Democratic lawmakers. A call to slow government spending helped Republicans seize control of the House of Representatives in November's elections.
House Majority Leader Eric Cantor said on Sunday that Republicans would not back an increase in the limit "unless there are serious spending cuts and reforms." He said all spending should be on the table, including for the Pentagon.
GETTING WORSE, NOT BETTER
That position may harden after the latest signs that government finances are deteriorating rather than improving.
The nonpartisan Congressional Budget Office on Wednesday said the budget deficit will soar nearly 40 percent to a record $1.48 trillion this fiscal year, largely because of a tax-cut package engineered by President Barack Obama and Republican lawmakers last month.
Geithner has said the United States intends to get its deficits under control, while defending past decisions to pump money into the economy to counter the 2007-2009 financial crisis.
The International Monetary Fund on Thursday warned that investors won't remain complacent forever and that a U.S. budget-cutting plan was needed soon to keep borrowing costs tamped down.
"In advanced economies where fiscal sustainability has not been a market concern, credible plans going well beyond 2011 need to be put in place urgently to lock in benevolent market sentiment," it said. [ID:nN27161289]
While the Treasury still has multiple steps it can take to ward off bumping the debt ceiling, eventually the issue will either come to a head that will either force lawmakers to acquiesce to another hike or the Obama administration to bargain for one.
A standoff would only heighten financial market worries that the United States could be pushed into a default -- an unlikely result and one that has never happened in the country's history. (Reporting by Glenn Somerville; Editing by Andrew Hay)