By Steven C. Johnson and Karen Brettell
NEW YORK (Reuters) - Ben Bernanke put markets on notice this week: Despite already having spent trillions of dollars to stimulate growth, the Federal Reserve would do more if inflation falls too far and the threat of deflation grows.
Bond investors are taking the Fed chairman at his word. If things get worse, some predict the central bank will go beyond targeting interest rates and move straight to outright buying of mortgage securities, municipal debt and even stocks.
"When I think of the Fed I think everything is on the table until it isn't," said Eric Green, chief economist and head of interest rate strategy at TD Securities in New York.
If the economy appears on the verge of deflation, the Fed will "have to go very big and be very creative, and that means munis are on the table, mortgage-backed securities, corporate (bonds), equities," he said. "Everything is possible because the Fed has broken new ground and they will continue to do so if they feel they have to, exit strategy be damned."
The Fed has pushed short-term interest rates to record lows and last week announced it would attempt to push down long-term rates by selling $400 billion of short-dated Treasuries to buy an equal amount of debt with maturities of seven years and up, in a policy dubbed "Operation Twist."
This was designed to help the housing market by lowering long-term borrowing costs. It would also encourage investors to sell Treasuries for higher-yielding assets, which should boost stocks and corporate profits, encourage hiring and investment and provide a jolt to consumer sentiment and prices.
THEORY AND REALITY
That, at least, is the theory.
But fear that the economy may already be in recession has been pushing down stocks, commodities and Treasury yields for several months. U.S. stocks <.SPX> are more than 10 percent weaker since the start of August.
As a result, market expectations for U.S. inflation have retreated to levels last seen in September 2010, shortly before the Fed began a $600 billion bond buying program, the second installment of a policy known as quantitative easing, or QE.
When asked about this after a speech on Thursday, Bernanke said, "if inflation falls too low or inflation expectations fall too low, that would be something we would have to respond to because we do not want deflation.
The expected rate of inflation over the next 10 years as measured by the gap between Treasury inflation-protected securities (TIPS) and cash government bonds fell as low as 1.70 percent last week. At 1.83 percent on Thursday, it was still below the Fed's unofficial inflation target around 2 percent.
St. Louis Fed President James Bullard chimed in on Thursday, saying he was troubled by the decline in market inflation expectations. But he added that deflation was not yet a risk and that the bar to more Fed easing remained high.
That could change, though.
"If inflation stays very low, that's going to create a clear path for more forms of unconventional easing," said Jim Caron, head of interest rate strategy at Morgan Stanley. "I don't know how much the market is paying attention to that. But I wouldn't count anything out."
With interest rates already at record lows, Caron said a QE3 would likely target assets other than Treasuries.
Mortgage debt is one candidate, and because the market is not as liquid as the government bond market, the Fed might have more success pushing investors into riskier assets.
During QE2, households, one of the largest groups of Treasuries buyers, simply increased investments in other low-risk debt such as agencies, municipal and corporate bonds when the Fed started buying Treasuries.
"The point would be to force (investors) into other risk assets knowing that the Bernanke put is no longer imagined, it's actually in place," Green said. "If the Fed is buying equities, it wants to create more favorable conditions, which means stronger risk assets, tighter credit spreads and lower rates."
Even as the risks rise, the Fed will have to tread carefully. Data showed core consumer prices, which remove energy and food costs, rose at a 2 percent rate in the 12 months to September, near the top of the Fed's comfort zone.
That seems to clash with signals from the TIPS market, but some say those signals may be misleading.
Philadelphia Fed President Charles Plosser, one of three central bank officials to vote against Operation Twist, said Thursday that Europe's debt crisis has increased the safe-haven appeal of U.S. government debt, with falling yields narrowing the spread between cash bonds and TIPS.
"One of the driving factors that led the Fed to embark on QE2 was indeed concern about deflation risk," said Michael Pond, Treasury and inflation-linked strategist at Barclay's Capital.
But this time, he added, "if the Fed only looks (at TIPS), they would likely be misguided here in thinking the market is pricing in disinflation."
(Editing by Burton Frierson and Dan Grebler)