Fed May Seek to Assure It Can Keep Rates Low Without Inflation

By Steve Matthews

June 24 (Bloomberg) -- Federal Reserve officials will probably seek today to reassure investors they can keep short- term interest rates at a record low without igniting inflation.

The Fed’s Open Market Committee, concluding a two-day meeting, may stress that increasing slack in the economy will contain consumer prices into next year, analysts said. Policy makers also will likely discuss how to avoid a jump in longer- term Treasury yields once they fulfill their commitment to buy $300 billion in Treasuries as soon as August.

At stake is heading off a further surge in borrowing costs fueled by concern that record Fed liquidity injections and unprecedented government borrowing will cause inflation to accelerate. That would endanger prospects for an economic recovery at a time when house prices continue to fall and unemployment approaches 10 percent.

“They would like to see longer rates lower,” said Stephen Stanley, chief economist at RBS Securities Inc. in Stamford, Connecticut, and a former Fed economist. “They need to finesse it so that people are not worried about inflation.”

The FOMC is scheduled to issue its statement around 2:15 p.m. today in Washington.

Policy makers will probably affirm plans to keep the benchmark federal funds rate near zero for an “extended period,” Fed-watchers said.

Extended Date

They will also probably debate whether to extend the term for buying the $300 billion of long-term Treasuries until the end of the year, according to Laurence Meyer, vice chairman of Macroeconomic Advisers LLC and a former Fed governor. At its current rate, the Fed will reach $300 billion by late August.

The plan to purchase the securities is scheduled to end in mid-September, while five other emergency-credit programs are due to end on Oct. 30. The Fed has also committed to buy up to $1.45 trillion of housing debt this year.

Yields on benchmark 10-year notes have climbed to 3.62 percent from 2.53 percent when the central bank announced its Treasuries-purchase program on March 18. While central bankers have indicated they accept the increase as long as it reflects expectations for an economic recovery, a further increase may put such a recovery in jeopardy.

Mortgage rates have risen in tandem with yields, potentially delaying an end to the housing market’s depression. The average 30-year mortgage rate increased to 5.59 percent earlier this month, the highest since November, before slipping to 5.38 percent in the week ended June 18, according to Freddie Mac, the McLean, Virginia-based mortgage-finance company.

Inflation Expectations

Inflation expectations have also increased. One such measure, the difference between yields on 10-year Treasuries and 10-year inflation-linked U.S. notes, rose to 1.84 percent yesterday from 1.41 percentage point at the start of last month.

Fed officials could flag in their statement that the gap between the economy’s actual and potential performance has widened, making it unlikely consumer prices will start climbing.

Industrial capacity in use dropped in May to 68.3 percent, the lowest level since records began in 1967. The unemployment rate, which was 9.4 percent in May, will probably rise this year to 10 percent, President Barack Obama said last week. Consumer prices in the 12 months to May fell 1.3 percent, the most since 1950, the Labor Department reported June 17.

Fed Governor Kevin Warsh said on June 16 a recovery isn’t assured this year. “The panic’s hasty retreat should not be confused with robust recovery,” Warsh said in New York.

Statement Language

At the same time, policy makers need to be wary about the impact on inflation expectations of any further commitment to unfreeze credit markets, some analysts said.

“They have to be really careful,” said Christopher Low, chief economist at FTN Financial in New York. “They may not be forceful because they are worried about how the market will react,” he said. “The Fed needs to communicate they are aware of the shift in inflation expectations and they take inflation fighting seriously.”

Low said that central bankers should avoid the impression that they will “monetize” U.S. budget deficits -- by creating the funds to buy government debt used to finance the shortfalls.

“They have to assure the bond market they are thinking about ways to reverse what they have done” by doubling the Fed’s balance sheet to $2.1 trillion, added Mark Vitner, a senior economist at Wachovia Corp. in Charlotte, North Carolina.

Federal Reserve Chairman Ben S. Bernanke highlighted in congressional testimony this month the “difficult decision” of timing the withdrawal of record liquidity. “You don’t want to remove accommodation so soon as to prevent the recovery from taking hold,” Bernanke said on June 3. “On the other hand, you don’t want to wait so long as to lead to inflation in the medium term.”

Among the emergency lending programs that are scheduled to expire Oct. 30 are those that provide funds or Treasury securities to brokers, money-market funds or companies: the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Money Market Investor Funding Facility, the Primary Dealer Credit Facility and the Term Securities Lending Facility.

To contact the reporter on this story: Steve Matthews in Atlanta at smatthews@bloomberg.net