Fed officials in debate over bond buys

NEW YORK (Fortune) -- How much should the Federal Reserve support the bond markets? The question, which has animated investors lately, was the subject of a debate at December's Fed meeting, according to minutes from that meeting released Wednesday.

The minutes showed that a few officials on the Fed's policy-setting committee contended it "might become desirable at some point in the future" for the Fed to expand its purchases of certain bonds, should the tepid economic recovery cool further.

The Fed said last year it would buy more than $1.5 trillion of Treasury, government agency and mortgage-backed securities to support the credit markets. The Fed has said it has already reached its target for Treasury purchases and aims to wind down the other programs in the first quarter.

Another official, however, "suggested that the quantity of planned asset purchases could be scaled back" in light of the improved market conditions and economic outlook. The names of the speakers aren't identified, but the minutes show officials continue to grapple with the scale and timing of their support for the credit creation that fuels economic growth.

"Their view is that they have stepped into a temporary gap in private lending with all these policies," said Jeff Miller, CEO of NewArc Investments in Naperville, Ill. "As they see private activity expanding, they're going to step back -- but not before."

The bond purchases weren't the only question on policymakers' mind. With the dollar having weakened over the past decade and the prices of gold and other commodities having risen, committee members "noted that any tendency for dollar depreciation to put significant upward pressure on inflation would bear close watching."

December's meeting concluded with the Federal Open Market Committee saying it would hold short-term interest rates near zero "for an extended period."

The FOMC cut its fed funds rate to a record-low range of 0% to 0.25% in December 2008, aiming to shore up the economy after credit markets froze following Lehman Brothers' bankruptcy.

That move and numerous other Fed financing programs have unleashed a flood of liquidity that helped to avert a deeper downturn.

But with signs emerging that the economy is slowly recovering, pressure is building on policymakers to show they are ready take away the punchbowl before growth really gets rolling, lest all the Fed's actions result in an inflationary spike a few years down the road.

The prices of long-term Treasury securities tumbled last month, giving long bonds their worst annual performance in at least three decades, as investors started betting a recovering economy and a crowded schedule of government bond sales would restore inflationary pressures and boost long-term interest rates.

The yield on the 10-year Treasury note rose to 3.85% on Dec. 31 from 3.28% a month earlier before falling to a recent 3.82%. Bond prices and yields move in opposite directions.

A continued rise in long-term interest rates could derail a tentative housing recovery, which would add to the strains on banks. Mortgage rates have risen five straight weeks, according to Freddie Mac, with the average 30-year fixed-rate mortgage hitting 5.14% last week, its highest level since August.

But policymakers led by Fed chief Ben Bernanke have said they are confident the central bank can slowly remove government support for the markets without causing an uproar.

The FOMC said last year it expects several emergency liquidity programs adopted at the height of the crisis to end as scheduled next month.

The committee has been debating possible sales of Treasury securities and other bonds purchased during the past year of so-called credit easing, though it hasn't yet reached consensus on that question.

The Fed has plenty of options at its disposal, board members stress.

"We have a wide range of tools for removing monetary policy accommodation when that becomes appropriate," Fed governor Elizabeth Duke said this week in a speech in North Carolina.

At the same time, Bernanke faces criticism over the Fed's failure to deal with the housing bubble before it turned into a roaring financial crisis, and over some of the unusual, ad hoc measures the Fed took as financial calamity loomed in 2008.

Among these are the Fed's support for Bear Stearns in the spring of 2008, its decision with the Treasury Department not to bail out Lehman Brothers in September and its support for a rescue of AIG (AIG, Fortune 500) just days later.

Anger over the Fed's handling of monetary policy and government bailouts promises to be a major theme in Bernanke's confirmation hearing before the Senate, which hasn't been formally scheduled but is expected this month.