Fed thinking of selling debt to withdraw stimulus

Minutes of the Fed's latest policy meeting in January suggested officials remain positive about the economy's prospects even as they worry about the impact of an elevated unemployment rate, which they see holding near the current 9.7 percent through 2010.

To combat the worst recession and financial crisis since the 1930s, the U.S. central bank has cut benchmark interest rates to near zero and bought more than $1.5 trillion in government and mortgage bonds to pump money into the economy.

The minutes offered a window into the Fed's thinking on how best to withdraw the extraordinary stimulus it has provided, but also revealed substantial disagreement among officials on the timing and sequencing of exit steps.

Several thought it important to begin a program of asset sales in the near future to ensure that the Federal Reserve's balance sheet shrink more quickly, the minutes of the January 26-27 meeting said.

Other policy makers, however, appeared worried that dumping mortgage debt into a fragile market might drive up mortgage rates, compromising the housing sector's tentative stabilization. U.S. housing starts rose 2.8 percent in January but at an annual rate of 591,000 units still stood at barely a quarter of their boomtime peak.

At the January meeting, the Fed held its target for interbank overnight rates in a zero to 0.25 percent range and reiterated a pledge to keep rates extraordinarily low for an extended period.

Kansas City Federal Reserve Bank President Thomas Hoenig dissented at the meeting because he was uncomfortable with the low-rate pledge. The minutes showed that he did not want to drop the vow altogether but simply tone it down.

There was no clear evidence in the minutes that his dissent had much sympathy within the Fed's policy committee, but Philadelphia Fed President Charles Plosser said on Wednesday the language could curtail the bank's wiggle room.

U.S. stocks briefly pared gains, the dollar rose and U.S. government debt prices extended losses after the minutes were released as investors braced for an eventual tightening in Fed monetary policy.

The consensus seems to be shifting, said Marc Pado, U.S. market strategist at Cantor Fitzgerald in San Francisco. This is step one for Fed watchers, but we're still several meetings away from a rate change.

THE SLACK DEBATE

Underlying the internal discord on the Fed's exit strategy are fundamental differences in economic theory. Officials diverge on how much a weak labor market and the economy's untapped productive capacity will dampen inflation.

The minutes showed officials do not believe a pickup in underlying inflation is an immediate concern, although many voiced anxiety that commodity prices could rise as the global economy gains traction, sparking broader inflation.

The Fed's quarterly economic forecasts contained in the minutes were slightly more optimistic than projections released in November.

Officials see U.S. gross domestic product rising between 2.8 percent and 3.5 percent this year, on the firmer side of the projections of private sector economists. Previously, the forecast range was 2.5 percent to 3.5 percent.

U.S. GDP grew at an annualized 5.7 percent pace in the fourth quarter, but few analysts expect that to be sustained.

In general, participants saw the upside and downside risks to the outlook for economic growth as roughly balanced, the minutes said.

WHAT, WHEN, HOW

The minutes uncovered plenty of debate surrounding what steps, or series of steps, the Fed should take first.

Most officials favored reducing the supply of reserves in the banking system before actually nudging higher the interest rate the central bank pays banks on their excess reserves. Raising that rate would encourage banks to park excess funds at the Fed and take that money out of circulation for a time.

However, several feared steps to reduce reserves would be interpreted as the opening salvo of a tighter policy, and should only be undertaken when policy makers are almost ready to raise rates.

The Fed said it would be ready by early spring to use mortgage-backed securities it holds as collateral in reserve-draining operations, and be able to conduct these transactions with a broader range of financial institutions soon after.

The minutes also referenced the possibility of implementing a corridor system, where the discount rate the Fed charges on direct loans to banks would serve as a ceiling for short-term borrowing costs and the rate paid on reserves would provide a floor.

Investors are bracing for the Fed to raise the discount rate in the near future, widening the gap between that rate and the target federal funds rate -- the central bank's main economic lever. Officials narrowed that spread during the heat of the credit crisis

Officials agreed in January such a move would be appropriate soon.