FED FOCUS-Fed to bond market: "We get it"

WASHINGTON, June 5 - Policy-makers at the U.S. Federal Reserve stepped up their anti-inflation rhetoric this week after a bond market sell-off delivered a sharp reminder that they ignore investors at their peril.

Extreme bond market volatility reflects uncertainty over the inflationary impact of aggressive Fed action to defeat the severe U.S. recession, and could cool the central bank toward further efforts to lift growth by buying up U.S. Treasuries.

Fed Chairman Ben Bernanke tried to placate concerns that the central bank will tolerate higher prices to ensure recovery, while a couple of regional Fed bank chiefs called for an exit strategy from so-called quantitative easing.

"This is a day of reckoning that the Fed would have hoped (would come) a year or two from now," said Gregory Hess, an economics professor at Claremont McKenna College in Claremont, California. "They have done big things and now they face the consequences."

The Fed has more than doubled its balance sheet to $2 trillion and has promised to purchase $1.75 trillion of mortgage-related debt and longer-term U.S. Treasuries in a bid to drive down private borrowing costs and battle recession.

"Some observers worry that the ballooning of the Fed's balance sheet may raise inflation because the Fed may face political and technical challenges when it tries to unwind these policies," San Francisco Federal Reserve President Janet Yellen told a Fed conference in Washington on Friday.

"While I have not found these arguments convincing so far, the recent rise in Treasury rates, if it is reflective of such concerns, is disconcerting," she said.

Until the current global crisis, quantitative easing has only ever been attempted before by Japan when it tried to dig its economy out of a devastating recession in the 1990s.

Now, in addition to the Fed, the European Central Bank, the Bank of England and the Bank of Japan are engaged in some form of quantitative easing, meaning the U.S. central bank is not alone in its dilemma.

Japan's earlier experience certainly did not lead to inflation. But the Fed's efforts are on a larger scale and come alongside a $787 billion tax cut and spending package put in place by the Obama administration and Congress.

"As fears of depression and deflation fade, market participants naturally start to think about what comes after the recession," said Dean Maki, chief U.S. economist at Barclays Capital in New York.

"The improvements in economic data and financial markets ... make the question more urgent of when and how the Fed will stop the balance sheet expansion and eventually shrink its balance sheet," he said.

A report on Friday that showed the pace of U.S. job losses slowed sharply last month led dealers in interest rate futures markets to ramp up bets that the Fed would begin raising overnight interest rates, which have been held near zero since December, by the end of the year. [ID:nN05276580]

TOUGH CALL

Bernanke told Congress on Wednesday that signs of an easing in the recession appeared to be pushing up long-term U.S. Treasury and mortgage rates, but he topped his list of explanations with investor worry over the anticipated supply of government bonds to fund a record budget gap.

Determining which factor is more important will be crucial in helping the Fed to decide if it should announce an expansion of its planned Treasury purchases at its next meeting on June 23-24 or remain in wait-and-see mode. Some analysts even think policy-makers will debate calling a halt to the buying.

Minutes of its last meeting in late April showed officials had discussed expanding the program. The Fed would be unlikely to do so if it feels the reason for higher yields is hopes for the economic recovery. But it might step in if technical factors were to blame, and Bernanke cited hedging activity in the mortgage-backed securities market as one possible culprit.

But Bernanke went to pains to assure markets that he took seriously their concerns about the way officials have battled the financial crisis, and said the Fed would not flinch from tightening monetary policy when the time was right.

"It's not going to be an easy call but we'll have to balance the risks on both sides -- not to go too soon and stunting the (recovery) and not going too late and having a bit of inflation," he told U.S. lawmakers.

Kansas City Federal Reserve Bank President Thomas Hoenig took a tougher line, warning that markets were sending a clear signal that inflation must not be ignored.

"I suggest strongly that we need to be alert to the markets' message and begin in earnest to bring monetary policy into better balance before inflation forces our hand," he said on Wednesday.

Hoenig, who will be a voter on the Fed's rate-setting committee next year, is a noted inflation hawk. But the need for the Fed to rein back policy accommodation at some point was also voiced by Cleveland Fed President Sandra Pianalto, who said the stimulus must be removed as recovery signs surface.

The Fed has various tools at its disposal that would allow it to tighten policy despite a balance sheet that could reach $3 trillion once its announced asset purchases are completed.

It has been thinking hard about how best to accomplish this task, and is now beginning to talk about it in the open.

"The Fed speakers are responding to market concerns, but also are trying to give out information about what form the exit strategy will eventually be in," said Maki.