FED SAW ECONOMIC GROWTH BUT RISK FROM INFLATION EXPECTATIONS

Washington, April 6 (Dow Jones)- Federal Reserve officials judged that the U.S. economy was gaining traction when they met three weeks ago, but highlighted the potential negative impact of rapidly rising commodity prices on inflation expectations, consumer spending and business investment.

"A significant increase in longer-term inflation expectations could contribute to excessive wage and price inflation, which would be costly to eradicate," the Fed said in minutes from its March 15 meeting, released with the customary lag on Tuesday.

At the meeting, the Fed maintained its easy-money policies while offering reassuring words about the economic outlook and signaling vigilance on inflation. And it appears most Fed officials want to complete the $600 billion bond-buying program set to end in June.

"A few members noted that evidence of a stronger recovery, or of higher inflation or rising inflation expectations, could make it appropriate to reduce the pace or overall size of the purchase program," the minutes said. "Several others indicated that they did not anticipate making adjustments to the program before its intended completion”.

The Fed started the bond purchases last year in an effort to stimulate the economy. In December 2008, the Fed dropped its short-term interest rate target nearly to zero, and last month reiterated that it would keep it there for "an extended period”.

Some Fed officials in recent weeks have worried that such policies are fueling inflation.

Officials at last month's meeting indicated increasing energy and commodity prices had fed a recent boost in headline inflation, but expected that rise to be temporary. They showed some concern, though, that businesses and consumers may not feel the same way.

"Accordingly, participants considered it important to pay close attention to the evolution not only of headline and core inflation but also of inflation expectations," the minutes said.

Analysts at the Royal Bank of Scotland said the minutes underscored the importance of stable inflation expectations. "In the Fed's opinion, if inflation expectations remain anchored, then underlying inflation will be little affected by the temporary rise in commodity prices," the analysts said. "Thus, the Fed will be watching gauges of inflation expectations as closely as the actual inflation measures themselves”.

Fed officials also discussed new sources of uncertainty in the economy, noting that "unfolding events in the Middle East and North Africa, along with the recent earthquake, tsunami, and subsequent developments in Japan, had further increased uncertainty about the economic outlook”.

Despite some risks, Fed officials said the economy is on firmer footing, with unemployment declining while consumer spending and business investment show signs of strength. The Fed also maintained its easy-money policies.

The minutes noted that the Fed is planning for the eventual exit from the current, exceptionally accommodative monetary policy.

"In light of uncertainty about the economic outlook, it was seen as prudent to consider possible exit strategies for a range of potential economic outcomes," the minutes said.

Since the March 15 meeting, several officials from regional Fed banks have spoken out with varying degrees of concern about the outlook for inflation and growth, indications that a vocal minority may want to cut the bond program short and start raising interest rates soon.

Minneapolis Fed President Narayana Kocherlakota last week said the Fed may need to increase short-term interest rates by year's end if underlying inflation rises as he anticipates. Kocherlakota said he expected "a big upward movement" in core inflation -which excludes volatile food and energy prices- from about 0.8% late last year to about 1.3% by year-end.

But Fed Chairman Ben Bernanke Monday downplayed inflation fears, saying the rise in global commodity prices is likely to be temporary and shouldn't translate into a broader inflation problem. The Fed chief was quick to add that if his prediction is wrong and inflation begins to mark strong gains, the central bank would respond.

Congress has given the Fed a dual mandate: to maintain low unemployment and stable inflation. Unemployment last month was 8.8% and inflation remains below its objective of 2%.

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