Fed to Keep Lid on Bond Buys

By JON HILSENRATH WASHINGTON -- Federal Reserve officials are unlikely to significantly boost purchases of U.S. Treasurys and mortgage-backed securities when they meet in late June, but could make other adjustments in the face of rising bond yields and fresh signs of an improving economy. Fed officials have become more confident recently that they have stabilized the economy and set the stage for recovery. But divisions are brewing within the Fed over whether it should do more to speed the healing, pause, or start pulling back to avoid an outbreak of inflation. Those crosscurrents are likely to inhibit bold new strokes by the Fed at its next meeting, in contrast to earlier in the year, when a bleak outlook spurred aggressive action. The Fed's bond-purchase programs are designed to drive up Treasury prices and push down interest rates across the economy. The bond and mortgage-debt purchases have been at the center of the government's efforts to jump-start economic activity. But as bond yields and mortgage rates rise, the Fed is struggling to gauge the effect of its buying and to decide how to proceed. Yields on 10-year Treasury notes fell Thursday to 3.862%, after Wednesday's brush with 4%. But they remain sharply higher than March's 2.5% -- a potential threat to economic recovery. Solid demand at a government auction of 30-year Treasury bonds bolstered the bond market on Thursday. Interest rates on everything from business loans to home mortgages tend to move in tandem with Treasury rates. If government-bond rates rise too much too fast, they could short-circuit a recovery by choking off consumer and business borrowing and spending. Fed officials aren't convinced that is happening yet, so they aren't inclined to use their muscle to restrain bond yields any more than they have already set out to do. That could change if their views of markets and the economy change. Fed officials say much needs to be hashed out at the next meeting. When officials convene on June 23 and 24 in Washington, one idea on the table will be to stretch out over a longer period of time planned purchases of Treasury securities or mortgage-backed securities. Doing so would avoid an abrupt, and perhaps disruptive, end to the buying and give the Fed time to assess the outlook. The Treasury has set out to buy $300 billion of Treasurys by the end of August. It is on a path to buy $1.25 trillion of mortgage-backed securities by the end of this year or early next year. So far, the Fed has purchased $156.5 billion of government bonds. Officials could also change the mix of their purchases. Despite the recent rise in mortgage rates, officials are reluctant to increase their planned purchases of mortgage-backed securities, which would tend to push down such rates. The Fed already has bought $555.9 billion of mortgage securities. Officials worry that increased buying would make the Fed too dominant in the market, deterring other investors from participating or causing big price distortions. The rate on 30-year fixed-rate mortgages climbed to 5.81% on Thursday, from 5% two weeks ago, according to HSH Associates. The five current Fed governors in Washington and the presidents of the 12 regional Fed banks intend to discuss at their June meeting how to manage their exit from their unconventional monetary policy, when the time comes. One worry is that if they buy too many securities now, it will be hard to unwind their programs later. Inside the Fed, several officials still believe that even if growth resumes, the economy will need more stimulus from the central bank because the unemployment rate is likely to remain above 9% for years and factories are still running far below capacity. Fed Chairman Ben Bernanke and others have argued the economic slack puts downward pressure on inflation. "This is not an environment in which inflationary pressures are at all likely for some time to come," former Fed Chairman Paul Volcker, who made his name as an inflation fighter, said in a speech in Beijing Thursday. Still, some Fed officials worry that if they wait too long to reverse the tidal wave of money they've pumped into the financial system, that could spark inflation -- a threat that bond markets might already be signaling by pushing up Treasury yields. "Just as there is slack, there is also an enormous amount of stimulus in the economy and coming into the economy," said Kansas City Fed President Thomas Hoenig in an interview. "Being too slow to remove our expansionary actions would very likely be inflationary." The Fed's task is complicated by the fact that it is using tools it has never used before. It has already cut the interest rate that banks charge each other on overnight loans -- once its primary economic-stimulus tool -- to zero, and it has vowed to keep it there for a while. It has also turned to bond buying and targeted lending. Another challenge on the June agenda is how to communicate Fed thinking about the complex set of "crosscurrents," as one official describes it. Fed officials believe markets may have gotten ahead of the economy, reacting to government data that the pace of job losses is slowing by anticipating an increase in the Fed's key short-term interest rates by year end. Some Fed officials see that as an overreaction. Even inside the Fed, officials find it hard to measure the effect of their unconventional policies and to decide how much bond buying is needed. Some research suggests that $100 billion of Treasury securities purchases results in interests rates falling 0.05 to 0.08 percentage points. But many top Fed officials have little confidence in such projections. In a Wall Street Journal survey released Thursday, 35 of the 50 Wall Street economists who responded, or 70%, said the Fed shouldn't increase its planned purchases of Treasurys. Some 64% said Treasury yields are rising because the economy is improving, and because investors are becoming less risk-averse and moving away from safe government bonds to riskier corporate debt and other securities. Most of those surveyed don't expect the Fed to raise short-term interest rates before the second quarter of 2010. Recently, the market has focused on government borrowing and the size of the deficit. Some officials worry that buying more government bonds could signal the Fed's willingness to accommodate large budget deficits. That could be inflationary, and could lead the bond market to push yields even higher. "The main danger of a Treasury purchase program is that people may wrongfully conclude that there is a risk that you are going to monetize the debt and reinflate," said William Dudley, president of the New York Fed, in an interview. Initially he was wary of the program, he said, but he became less so in March after the Bank of England announced a similar plan that didn't spook investors. Fed officials have been admonishing lawmakers to do more to restrain the deficit. Higher yields on Treasurys "can be seen as an expression of creeping doubt that the American polity, and more specifically the policy community, is up to the sacrifices, trade-off decisions, and the courage of convictions the situation requires," said Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, in a speech Thursday. Many officials believe bond yields are rising now because investors are shifting from low-risk securities such as Treasurys to higher-risk ones such as corporate bonds, a sign of improving confidence in markets. They also believe investors are less worried about an even deeper downturn that would cause deflation, a dangerous downward spiral in consumer prices. Fed officials take comfort in other developments in financial markets. Though mortgage rates have risen, many other private-sector borrowing rates are coming down. For example, the London interbank offered rate -- the rate at which banks make short-term loans to one another -- has declined. Rising stock prices are also helping improve financial conditions and bolster household wealth. "Conditions in a number of financial markets have improved since earlier this year," Mr. Bernanke said last week in testimony to Congress. Write to Jon Hilsenrath at jon.hilsenrath@wsj.com