FOMC Debates Asset Purchases, Inflation as Economy Strengthens

By Scott Lanman

Jan. 7 (Bloomberg) -- Federal Reserve officials discussed whether the economy is strong enough to allow their $1.73 trillion of asset purchases to end in March and differed over the risk of inflation, minutes of their last meeting showed.

A few policy makers said it “might become desirable at some point” to boost or extend securities purchases aimed at lowering mortgage rates, while one person sought a reduction, according to minutes of the Dec. 15-16 meeting of the Federal Open Market Committee released in Washington yesterday. On inflation, some officials said slack in the economy will damp prices, and others saw risks from the central bank’s “extraordinary” stimulus.

The Fed’s debate is intensifying while Chairman Ben S. Bernanke and his colleagues are trying to withdraw unprecedented stimulus and emergency lending programs without impeding efforts to sustain a recovery. Officials judged economic and job growth “would be rather slow relative to past recoveries from deep recessions,” the Fed said.

“They’re focused on a balancing act, wrestling with a recovery that’s gaining solid footing but that remains fragile,” said Paul Ballew, a former Fed economist who’s now a senior vice president at Nationwide Mutual Insurance Co. in Columbus, Ohio. “The Fed is keeping some levers out there as options.”

Short-term Treasuries rose after the report. Two-year U.S. government bonds reversed losses, with the yield falling two basis points to 0.99 percent in New York. A basis point is 0.01 percentage point. The Standard & Poor’s 500 Index was little changed at 1,137.14.

‘Expectations Anchored’

“To keep inflation expectations anchored, all participants agreed that monetary policy would need to be responsive to any significant improvement or worsening in the economic outlook and that the Federal Reserve would need to continue to clearly communicate its ability and intent to begin withdrawing monetary policy accommodation at the appropriate time and place,” the minutes said.

Policy makers in the Dec. 16 statement following their meeting said the labor market is stabilizing, while repeating a pledge to keep interest rates “exceptionally low” for an “extended period.” The Fed said most lending programs would expire as scheduled on Feb. 1 because of “improvements in the functioning of financial markets.”

The FOMC, in a unanimous decision, left its target for the benchmark interest rate unchanged in a range of zero to 0.25 percent and left unchanged its plans to buy $1.43 trillion of housing-finance debt through March. Fed policy makers next meet Jan. 26-27 in Washington.

‘Policy Stimulus’

“A few members noted that resource slack was expected to diminish only slowly and observed that it might become desirable at some point in the future to provide more policy stimulus by expanding the planned scale of the committee’s large-scale asset purchases and continuing them beyond the first quarter,” especially if the economic outlook or mortgage market deteriorated, the minutes said.

One member said the Fed could reduce planned asset purchases because of improvement in financial markets and the economy, and “that it might become appropriate” to start reducing asset holdings “if the recovery gains strength over time.”

The Fed is buying $1.25 trillion of mortgage-backed securities issued by housing-finance companies Fannie Mae, Freddie Mac and federal agency Ginnie Mae. The central bank began the program in January 2009.

Fannie, Freddie

The Fed separately purchased $300 billion of Treasury securities from March through September 2009 and is buying, through March, $175 billion of corporate debt issued by government-backed Fannie and Freddie and the government- chartered Federal Home Loan Banks.

Officials “generally thought the most likely outcome” was for economic growth to “gradually strengthen over the next two years,” helping reduce joblessness. Still, the “weakness in labor markets continued to be an important concern.”

At the same time, Fed officials “noted that any tendency for dollar depreciation to put significant upward pressure on inflation would bear close watching,” the central bank said. Some policy makers saw “upside” inflation risks because of investor concerns about Fed stimulus and federal budget deficits, the Fed said.

“The division on inflation is a very central one in terms of how it gets resolved, in terms of how quickly and when they begin the rate process,” said Bruce Kasman, chief economist at JPMorgan Chase & Co. in New York.

Rate Forecast

Policy makers won’t raise their target for overnight lending among banks until the third quarter of this year, according to the median of 62 forecasts in a Bloomberg News survey of economists taken early last month.

The minutes said that the New York Fed’s open market desk “was continuing to develop” the capacity to conduct reverse repurchase agreements using agency mortgage-backed securities collateral and expects the work to be finished in the first half of this year.

The New York Fed is also “exploring the operational issues associated with expanding potential counterparties” for reverse repurchase agreements beyond the 18 primary dealers, the minutes said.

In a reverse repo, the Fed lends securities for a set period, draining cash from the banking system. At maturity, the securities are returned to the Fed, and the cash to the 18 primary dealers that act as counterparties to the central bank.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net.