-->WASHINGTON, May 29 (Reuters) - Buying longer-term government debt could prove to be the Federal Reserve's best anti-deflation tool if it ran out of room to cut interest rates, but such a strategy is not without problems, researchers at the Dallas Federal Reserve Bank said.

In a paper posted on the regional Fed bank's Web site, economists Evan Koenig and Jim Dolmas said the issue is ripe for consideration because the Fed has little room to maneuver on short-term rates and the economy may need more stimulus.

"Since August... the incipient (economic) recovery hasn't unfolded according to plan," the researchers said.

"We're hopeful that positive trends will re-emerge now that the Iraq situation has been more-or-less resolved. But if we're wrong, or if another adverse shock hits the world economy, then new stimulus will be required."

The authors said that if the benchmark overnight rate were to drop much further from its current low of 1.25 percent, popular money market mutual funds could find it difficult to cover their costs -- an issue Fed chief Alan Greenspan (News) touched on in congressional testimony last week.

Because of the market stress a low overnight rate might cause, many economists on Wall Street think the Fed could turn to so-called unconventional policy tools once the rate reached 0.75 percentage point if further stimulus were needed.

Dallas Fed Research Director Harvey Rosenblum has said Fed policymakers would discuss"unconventional" tools at their next meeting on June 24-25.

The authors outline a number of tactics the Fed could use, but they hone in on the idea of buying longer-term government debt.

"In the event it must act alone, the Fed's best policy option is probably open-market purchases of longer-term government bonds," they said. The Fed currently conducts open market operations in short-term securities only.

They warn, however, that calibrating such operations could prove difficult.

"No one, we believe, has a good quantitative sense of the mechanics of this strategy -- that is, what size operations are needed to secure a given stimulus?" Koenig and Dolmas said.

"If standard policy options are exhausted, the Fed's quiver is by no means empty. But the arrows that remain are less familiar and, perhaps, not quite as straight as the ones that have already been fired."

One of the other measures they said the Fed could pursue would be to substantially weaken the dollar.

But they cautioned that a policy of foreign exchange intervention would, in effect, be conducting a monetary contraction in the economies of U.S. trading partners.

"If the foreign central bank was attempting to pursue a neutral or expansionary policy, the Fed's action might generate some consternation or even a policy response," they warned.

The researchers also said it would be possible for the Fed to essentially underwrite a large expansion of fiscal policy by purchasing any fresh government debt.

They further said the idea of eliminating the so-called zero-bound problem with interest rates by instituting a"carry tax" on money merited further study.

"This is particularly the case if achieving and maintaining price stability makes bumping up against the zero interest rate bound a more frequent event," they said.




RE: bunch of idiots...
Thomas