Fed likely to end bond buying, may signal caution on rate hikes

By Jonathan Spicer, Michael Flaherty and Ann Saphir

REUTERS - The Federal Reserve is likely to reassure investors later this month that it won't stand idle if global turbulence threatens the U.S. economy, but a proposal from one top policymaker to keep on buying bonds looks to be a bridge too far.

James Bullard, who heads the St. Louis Fed, suggested on Thursday that sticking with bond purchases for a few more months would give policymakers the time needed to assess a recent deterioration in the inflation outlook.

"Inflation expectations are dropping in the U.S. and that is something that a central bank cannot abide," Bullard said on Bloomberg Television.

A sharp decline in the unemployment rate over the past year had given the U.S. central bank confidence it could bring its so-called quantitative easing of monetary policy, or QE, to an end at its next meeting on Oct. 28-29, and it had bolstered the forecast of many officials for a mid-2015 interest rate hike.

Indeed, Bullard said he was sticking with his projection for a first quarter rate increase for now.

But mounting signs of weakness overseas, particularly in euro zone powerhouse Germany, and a related drop in global stock markets have led investors to question the central bank's resolve. Perhaps most troubling for the Fed, bond market measures of inflation expectations have turned sharply south.

Minneapolis Fed President Narayana Kocherlakota, who is seen as one of the officials most worried about the U.S. recovery's strength, told bankers and farmers in Billings, Mont., that a rate hike at any time in 2015 would be "inappropriate."

The Fed has been struggling for years to get inflation back up to its goal of 2 percent.

Speaking on the sidelines of an event in Washington, Bullard told Reuters a "QE pause would possibly send the signal that we do want to keep inflation expectations stable."

Economists, however, said such a dramatic course change was not needed, although the Fed would want to demonstrate sensitivity to the risk that global weakness, dollar strength and a loss of stock wealth could undermine the U.S. recovery. Traders have already pushed their rate-hike expectations into late next year.

"I don't expect the Fed at this stage to change course," former Richmond Fed President Alfred Broaddus told Reuters. "But if the selloff continues and threatens the domestic economy, they would have to signal that there will be more accommodation in one way or another."

TWEAKING THE STATEMENT

After a sharp selloff, U.S. stocks inched higher on Thursday, helped by economic reports suggesting economic vigor. Still, the dollar has continued its climb, causing measures of medium-term inflation expectations to ease and underscoring the threat of persistently low inflation.

"If this state of affairs persists heading into the late October meeting, it could prompt some mention in the statement," the Fed will issue, said JPMorgan economist Michael Feroli.

The central bank could reinstate a reference to the risks posed by persistently low inflation or augment its promise to wait a "considerable time" after ending bond buys to raise rates by tying it to a pick-up in inflation expectations, he said.

In an interview with Reuters on Wednesday, San Francisco Fed President John Williams suggested a similar approach to firming the Fed's forward guidance in the face of excessively low inflation.

If "inflation isn't moving up at all, and the economy is not growing beyond trend, you would want to strengthen that guidance," Williams said. "It could move forward guidance to being tied more to our inflation forecast or other things like that."

But Williams said data so far had kept him optimistic, and that he had not shifted his view that rate hikes could reasonably start in mid-2015. A number of other Fed officials, including Fed Vice Chair Stanley Fischer and New York Fed chief William Dudley, have also said in recent days a mid-2015 rate hike still seemed appropriate.

Meanwhile, the hawkish chief of the Philadelphia Fed, Charles Plosser, said the selloff was not yet significant enough to hurt the economy or garner a response from the central bank.

The Fed should not overreact as long as the domestic economy looks stable, he told reporters in Allentown, Pennsylvania.

Futures markets show bets on the timing of a Fed interest rate rise have fallen back to October or December of 2015, from the middle of the year just a few weeks ago.

"Given the current uncertainty, it would be unwise for the Fed to be too specific," said former Fed Governor Randall Kroszner. "My hunch is they are trying to re-estimate their forecast."

(Reporting by Jonathan Spicer and Michael Flaherty; Additional reporting by Ann Saphir and Krista Hughes; Editing by Tim Ahmann and Chizu Nomiyama)