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Dove-hawk tradeoff could mean earlier rate rise

The Federal Reserve building is seen in Washington June 19, 2012. REUTERS/Yuri Gripas

By Ann Saphir and Jonathan Spicer

SAN FRANCISCO/NEW YORK (Reuters) - A possible tradeoff between opposing camps at the U.S. Federal Reserve could bring about an earlier-than-expected interest rate rise while keeping the U.S. central bank's balance sheet larger for longer.

Comments from officials anxious to tighten monetary policy as well as from those who want it to remain as accommodative as possible suggest they may balance the timing of a rate rise against when the central bank's massive securities portfolio should shrink.

Policymakers struck a similar compromise in December when they twinned their decision to start trimming bond purchases with an even stronger promise to keep rates near zero well into the future. The purchases are expected to end later this year.

To continue dialing back the Fed's aggressive policy accommodation, officials must next raise rates and stop reinvesting proceeds from maturing Treasuries and mortgage bonds the central bank holds. The timing of those moves could have big consequences for the economy and global financial markets.

Even though a move on either front is unlikely until the first half of 2015 at the earliest, officials have already begun to strategize over the best way forward. Those discussions are likely to be front and center when Fed officials next meet on June 17-18.

William Dudley, the influential chief of the New York Fed, nodded to the tradeoff last month when he said he would rather not halt reinvestments until after the first rate rise.

Left unsaid - and largely overlooked by investors - is that topping up the balance sheet for longer than previously expected implies support for an earlier rate rise, according to current and former Fed officials. Otherwise, policy would be looser than intended, they said.

A week later Charles Plosser, the hawkish head of the Philadelphia Fed, told reporters that officials who want to keep the balance sheet large would "be faced with the task of raising interest rates higher and faster than you otherwise might have chosen."

The decision over when to stop reinvesting involves a relatively tiny fraction of the Fed's $4.5 trillion balance sheet, at least for the next year or so.

In 2015, if officials choose to stop reinvesting, the Fed's Treasuries portfolio would shrink anywhere from $353,000 to $1.45 billion in a given month, depending on what was due to mature. The mortgage portfolio could shrink more quickly as Americans prepay their home loans, though the extent will depend on mortgage rates and other factors.

But as the central bank's hawkish minority and its dovish majority including Dudley and Fed Chair Janet Yellen attempt to come to terms on how to move on from the crisis era, the decision is looming larger than mere dollars suggest.

"This debate is probably a proxy for when and how to tighten," said former Fed Vice Chair Donald Kohn, who is now a senior fellow at Brookings Institution. "Interestingly, the sooner and faster you let the portfolio decline, the greater the delay in raising short term rates."


That delay is something even doves like Dudley want to avoid.

In a wide-ranging speech on May 20, Dudley warned that shrinking the balance sheet could inadvertently convince markets that interest-rate hikes were imminent, raising borrowing costs across the economy and slowing the recovery.

The speech caused prices on 5- and 10-year U.S. Treasuries to rise as investors moved to price in what they perceived to be a looser Fed policy because the central bank's long-standing plan had been to start shrinking the balance sheet before raising rates. At the same time, traders kept bets in place that the Fed will wait until July of next year before raising rates.

But the message, which San Francisco Fed chief John Williams echoed separately the following day, may have been at least equally hawkish. Dudley emphasized the need to lift rates - which have been close to zero for five-and-a-half years - to give the central bank room to maneuver to deal with any future shocks.

"Many have viewed Dudley's remarks on the dovish side thinking that the Fed is in no rush to shrink its balance sheet, but I think they miss the point," said Standard Chartered Bank economist Thomas Costerg. "Dudley rather made clear that the Fed wants to regain some flexibility with the interest rate tool."

A Reuters survey last week found 12 of 17 primary dealers expect the Fed to halt reinvestments from maturing bonds after, or around the same time as, it lifts the key federal funds rate. A month ago, most expected the move to come before the rate rise.


If a compromise emerges, it wouldn't be the first time U.S. central bankers fretted about an outsized market reaction to a seminal policy change, and found a middle ground to avoid it.

In December, when the Fed announced the first modest $10 billion cut to its monthly asset purchases, minutes of the meeting show officials wanted to reinforce their commitment to low rates to "mitigate the risks of an undesired tightening of financial conditions" brought on by the cut.

As the hawkish Dallas Fed President Richard Fisher put it at the time, "I didn't find the (low-rate promise) to be too high a price to pay for that cutback of $10 billion."

Fed officials, both hawks and doves, have since become increasingly worried that keeping rates low for so long could fuel excessive risk-taking by investors. That has become one more reason they may agree to allow rates to rise a bit sooner, especially with robust job growth and other signs of gathering momentum in the economy.

Not all hawks, however, have signed on. Kansas City Fed President Esther George said recently that she wants to first stop topping up the balance sheet, and then raise rates, both sooner and more steeply than the current Fed forecast allows for. Jeffrey Lacker of the Richmond Fed has similarly called for an immediate end to reinvestments, though he acknowledged his view is in the "distinct minority."

(Reporting by Ann Saphir and Jonathan Spicer; Editing by Tim Ahmann and Martin Howell)