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U.S. Fed struggled with 2009 bailouts, bond-buying: transcripts

The sun rises to the east of the U.S. Federal Reserve building in Washington, July 31, 2013. REUTERS/Jonathan Ernst

By Michael Flaherty, Howard Schneider and Jonathan Spicer

WASHINGTON/NEW YORK (Reuters) - The Federal Reserve struggled with the message being sent by its role in bank bailouts and worried about the impact of a bond-buying program aimed at easing the 2007-2009 financial crisis, according to transcripts released by the U.S. central bank on Wednesday.

The transcripts from Fed meetings in 2009 reveal intense discussions on how to prop up the U.S. banking system and nurse an economy reeling from the biggest financial shocks since the Great Depression.

They also indicate that central bank officials anticipated a faster economic recovery and were laying out plans on how to exit the Fed's stimulus program long before they were ready to make the transition.

In a prescient view of future policy, then-San Francisco Fed President Janet Yellen expressed concern about proposing an exit plan too soon.

"I want to emphasize that we have to be very careful not to signal an early end to policy stimulus," Yellen said at a policy-setting meeting that June. "The outlook over the next several years remains disturbing," added Yellen, who took over as Fed chief in February 2014.

The transcripts, released with a customary five-year lag, capture what was a tumultuous year for the U.S. economy. With the collapse of Wall Street firm Lehman Brothers in its rear-view mirror, Fed and other government officials were scrambling to avert further meltdowns in the financial system.

The S&P 500 index fell to its lowest level in 12 years in March 2009 and unemployment soared to a 10-percent recessionary high that October.

"Until the reinforcements arrive, I don't think we have much choice but to try to work with other parts of the government to prevent a financial meltdown," then-Fed Chairman Ben Bernanke said during an unscheduled Jan. 16 conference call, shortly after Bank of America (BAC.N) announced massive fourth-quarter losses.

The Charlotte-based bank's losses, driven by its emergency takeover of Merrill Lynch, prompted the Fed to step in with financial support, which ruffled some central bank officials.

"I am curious as to whether we envisioned this as a possibility," Dallas Fed President Richard Fisher asked during the Jan. 16 call. "If so ... what reasonable probability did we assign when that merger was announced that we might have to step up to the plate?"

When another Fed official raised a similar concern, Bernanke agreed that the Fed's role in the rescue of Wall Street banks was "uncomfortable," but said it was better than other options and that the U.S. Treasury was taking the bulk of the fiscal risk.

STIMULUS DEBATE

"I think that just crossing the Rubicon will have a significant announcement effect because it will signal our willingness to do more if necessary in the future," Bernanke told the Fed's policy-setting committee that March, as officials debated a $1.15 trillion increase in the asset purchases.

Greater confidence in the financial system returned after the May 2009 release of the so-called stress tests on banks. The Fed pushed ahead with its bond-buying program, though the path forward was unclear at the time, the transcripts showed.

According to transcripts of the June policy meeting, staff made two presentations on an "exit strategy" from the unconventional monetary policy accommodation, with Bernanke telling colleagues: "I promised we would focus today a good bit on our exit strategy, that is, on how we're going to unwind the policies that we have put in place."

But it would take the Fed five years before it began implementing the plan. It ended three rounds of bond-buying last October, after adding more than $3 trillion to its balance sheet.

New York Fed official William Dudley said at the June meeting that he was worried the Fed risked chasing its tail with bond-buying if the pace of purchases was altered each month to pursue a particular interest rate level in mortgage or other markets.

"I mean, talk about potentially having severe cliff effects," Dudley said. "I'm going to buy more as rates go up? What happens if rates go up more?"

The outlines of a debate that continues to rage today already existed at that June meeting, the transcripts show, with Fed staff immediately pointing to an interest rate the Fed pays on excess bank reserves (IOER) as a key tool to eventually help tighten policy.

And Yellen pointed out that while the perception that the Fed was printing money with abandon was "misguided," the central bank needed to say it would not tolerate high inflation to avoid risking damage to its credibility.

In one of the transcripts, Yellen joked that "things are now so bad that I actually open the Greenbook with greater trepidation than my 401(k)."

For a blog on the transcripts: http://blogs.reuters.com/macroscope/2015/03/04/transcripts-show-just-how-scary-things-were-getting-for-yellen-and-the-fed-in-2009/

(Additional reporting by David Chance; Editing by Paul Simao)

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