US interest rates to be kept low to contain inflation

Financial markets have not fully understood that the U.S. Federal Reserve's pledge to keep interest rates exceptionally low for an extended period means they will stay low beyond when officials normally would raise them, a top Federal official said .

"I don't think markets have really digested what that means," St Louis Fed President James Bullard said in an interview.

The Fed's strategy is aimed at promoting a future rise in inflation, which should provide an immediate boost in activity in anticipation of a future boom, but that hasn't happened, Bullard said.

The St. Louis Fed official's comments suggest the Fed will be in no hurry to raise rates when signs of an economic rebound take firmer hold and that the central bank will be willing to tolerate higher levels of inflation over the short term as it nurses the ailing economy back to health.

The Fed chopped interest rates to near zero at the end of last year to counter the effects of the worst financial crisis since the Great Depression and an intensifying recession.

Bullard, who will be a voting member of the Fed's interest rate setting panel next year, said economic growth should return in the third and fourth quarters this year.

"I think we are turning the corner," he said on the sidelines of the annual Fed mountain retreat.

With interest rates near zero, the Fed has funneled vast amounts of funds to financial markets to try to stimulate economic activity.

Bullard said purchases of long-term securities by the central bank have successfully expanded the monetary base -- the amount of money in the economy. Expanding the monetary base has diminished risks from deflation in 2009, he said.

However, the effect of those long-term purchases in lowering borrowing costs is more ambiguous, Bullard said.

The Fed's announcement of those programs brought interest rates down, but those rates rose again, he said.

Many analysts worry that the Fed's aggressive policies to revive the economy are sowing the seeds for a spike in inflation.

With its vast expansion of money in circulation, the Fed is thinking about how it can effectively take money out of circulation by paying banks interest on the reserves they hold at the central bank, Bullard said. If the rate it pays is high enough, banks will keep reserves at the Fed and the money will not fuel unwanted inflation by sloshing around in the economy.

The Fed is counting on its ability to pay interest on bank reserves to keep a lid on inflation when the economy gains traction. But that strategy did not work as anticipated in late 2008 when rates were still above zero in part because mortgage finance companies Fannie Mae and Freddie Mac do not earn interest on reserves.

"We have got some work to do there, but those are technical issues, we'll work out those issues, and we'll put a floor under the federal funds rate," Bullard said.

If paying interest on reserves does not succeed in getting banks to keep their money out of general circulation, then the Fed would have to start selling off some of its longer-term securities to prevent unwanted inflation, he said.

As economic prospects have begun to improve, the Fed has begun to let some of its long-term securities buying programs phase out.

Another emergency facility aimed at stimulating lending has been extended for commercial real estate loans.

But that program, the Term Asset-backed Securities Loan Facility, or TALF, should end in six to nine months if markets continue to improve, Bullard said