The Federal Reserve could sell some assets later this year in an effort to whittle down its bloated balance sheet to avoid inflation, a senior Federal Reserve official said on Monday.

The Fed's purchases last year of longer-term Treasuries and other debt, undertaken to help revive the economy, were financed by adding cash to the financial system. But leaving large amounts of cash sloshing around as the economy strengthens risks fueling inflation.

Maybe you get in the second half of 2010 or something like that, if things are going pretty well, maybe then you'd sell a little bit at that point and you'd try to see how the market reacts, St. Louis Federal Reserve Bank President James Bullard told Reuters in an interview.

The U.S. central bank should try to get its balance sheet, which has ballooned by more than $1 trillion, down to a normal size before the next recession strikes to ensure it has the ammunition it needs to counter a downturn, Bullard said.

After the Fed slashed interest rates to near zero in late 2008, it launched a buying spree that also included mortgage-backed securities and debt issued by housing finance agencies to provide further support for the economy.

SALES BEFORE RATE HIKES

Bullard, who is a voting member on the Fed's policy-setting panel this year, said his preference would be to begin selling some assets before raising interest rates, although he said not all Fed policymakers were likely to see it his way.

He said the idea would be not only to get the balance sheet back to a pre-crisis size, but to return it to holdings of mostly U.S. Treasury securities.

The St. Louis Fed chief has long been an advocate of more actively managing the Fed's assets -- either by selling them or by leaving open the option of buying more if the economy stumbles anew. The consensus view at the Fed favors shuttering the purchase programs as planned and relying on rate hikes initially to tighten financial conditions.

However, with an economic recovery seemingly on track, Bullard made clear officials had begun to debate how best to normalize the Fed's balance sheet. Fed Chairman Ben Bernanke could shed more light on the central bank's plans in congressional testimony on Wednesday.

Bullard said markets would be disrupted if they came to believe the Fed was planning large-scale sales of mortgage-backed securities. However, he said the idea of gradual sales as a strategy is under discussion.

Selling has more sympathy than you might think. It's more a question of timing and speed, Bullard said.

You'd kind of want the situation to be back to normal in some kind of time frame before the next storm comes for the economy so that at that point you'd have a fresh set of tools and you can react at that point, he said. There will be a lot more discussion going forward about how exactly to do this.

INFLATION EXPECTATIONS SEEN RISING

The Fed's unprecedented policy actions helped lift the U.S. economy out of its deepest downturn since the 1930s. After contracting for four straight quarters, the economy grew at a 2.2 percent annual rate in the third quarter of last year and a 5.7 percent pace in the final three months of the year.

Bullard said the economy should grow at an annual rate above 3 percent in the first half of this year, adding that unemployment may have peaked. The U.S. jobless rate dropped to 9.7 percent in January from 10 percent in December.

The Fed is scheduled to wrap up its purchases of $1.43 trillion in mortgage-related securities by the end of next month. The program was undertaken to lower mortgage rates and prop up the struggling housing market.

Bullard said he does not expect a substantial jump in mortgage rates when the program ends, as some fear.

I think it will be seamless, he said.

Further emphasizing his concerns about preventing inflation, Bullard said inflation expectation are at or above the Fed's implicit target range. Central bankers lay great stress on holding inflation expectations in check because they believe doing so is key to keeping inflation at bay.

If the data keep coming in as expected and the economy keeps improving, then those will continue to ratchet up unless the central bank sends some signals that, 'No, we intend to keep inflation close to target,' he said.

Bullard said that if the rise in inflation expectations began to look troubling, the Fed could discard its pledge to hold interest rates exceptionally low for an extended period, even if unemployment remained high.

We know that the expectations are very important to how these things evolve, and so if those started to get out of hand, we really have to come back in and send a signal to the market, he said. It would trump everything.

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