July 7 (Bloomberg) -- Goldman Sachs Group Inc. says when it comes to inflation, the Federal Reserve can relax. That kind of talk makes Morgan Stanley nervous.

Joachim Fels, co-chief global economist at Morgan Stanley, sees a risk that the Fed will keep the easiest credit since the Great Depression for too long. Ed McKelvey, U.S. economist at Goldman in New York, says those concerns are overblown, and that officials have time to deploy as many as 10 options for ending their $1.1 trillion aid to the banking system and economy without letting consumer prices climb.

The debate underscores a widening division among economists over whether the central bank will hold onto the gains it’s achieved in fighting inflation over the past three decades. Record liquidity injections and a projected federal budget deficit of $1.85 trillion threaten to undermine that legacy.

“The greater risk is they keep accommodation too long rather than tighten too quickly,” Fels, who’s based in London, said in an interview. “The price they would then pay is higher inflation for keeping the economy afloat.”

A measure of inflation expectations watched by Fed officials rose “closer to the 2 percent level” in recent months after being “very negative late last year,” St. Louis Fed President James Bullard said in a June 30 presentation in Philadelphia. He also said investors “are not expecting a lot of inflation over the next five years.”

The Fed’s preferred price gauge, which excludes food and energy prices, rose 1.8 percent in May from a year earlier. Fed officials expect inflation in a range of 1.7 percent to 2.0 percent over the longer term, according to minutes of April’s Federal Open Market Committee meeting.

Meltzer’s View

“I agree with Morgan Stanley that the markets are too sanguine about inflation,” said Allan Meltzer, a Fed historian and economics professor at Carnegie Mellon University in Pittsburgh. “The Fed absolutely has the tools and know-how, but the question is, will they have the guts to use them? I don’t think there is a snowball’s chance in hell they will be willing to tighten to slow inflation down.”

Goldman Sachs says the risk is in the other direction, that the Fed may have a tougher time easing credit further should the economy deteriorate. Jan Hatzius, the company’s chief U.S. economist in New York, said in a July 1 research note that it’s “very unlikely” the Fed will “lose control” of inflation and that the Fed should err on the “accommodative side” of monetary policy.

‘Screw-Up’ Scenario

“The market seems to have a bias in its thinking that somehow the Fed is going to totally screw up,” resulting in inflation, McKelvey, who used to work at the Fed, said in an interview. He cited conversations with clients and what he’s read in the press, as well as the rise in Treasury yields and trader expectations of Fed interest-rate increases in recent weeks.

McKelvey, who wrote a June 30 note outlining the Fed’s options, cautioned there’s no guarantee the Fed will get it right, and “political constraints” might prevent the central bank from using its tools.

The Fed lowered its main interest rate almost to zero in December, switching to asset purchases and credit programs as the main policy levers. Chairman Ben S. Bernanke is leading plans to buy as much as $1.25 trillion of mortgage-backed securities and $200 billion of federal agency debt by year-end, along with $300 billion of long-term Treasuries by September.

Bernanke’s Options

Bernanke has three sets of tools, about 10 options total, for unwinding credit, McKelvey said. They include the reduction or end of non-emergency and emergency lending programs; selling or ceasing purchases of securities; and reducing bank reserves using tools such as the issuance of Fed debt.

“This one’s easy: Morgan Stanley is wrong and Goldman is right,” said Mark Gertler, a New York University economist and research co-author with Bernanke. “The Fed will be able to contain inflation pressures through a combination of raising interest rates and unwinding its balance sheets.”

The expansion of the Bank of Japan’s balance sheet also had no effect on inflation in that country, Gertler said.

The Fed took a first step last month toward ending its efforts to revive credit, deciding to let one emergency lending program expire and trim two others. Bullard said last week that policy makers need to craft a broader plan for unwinding the asset purchases to reduce inflation risks and bolster confidence in an economic recovery.

“The Fed needs to reduce some of the uncertainty in markets about how the exit strategy looks,” said Fels. “They can’t tell us when, but there needs to be more transparency on the how.”

Interest on Deposits

Some top Fed officials have said they plan to rely on raising the rate paid on banks’ deposits with the Fed as a major component of the central bank’s strategy to tighten credit.

Bernanke has a chance to give a more detailed outline of the Fed’s exit strategy on July 21, when he delivers the Fed’s semiannual monetary policy report to Congress and testifies before the House Financial Services Committee.

The Fed has increased total assets on its balance sheet by $1.1 trillion in the past year to $2.01 trillion as of July 1 to unfreeze credit markets and support banks’ demand for cash. Short-term lending to commercial banks and bond dealers has declined in recent weeks, owing in part to falling costs for private borrowing.

Yellen Warning

Goldman’s views may be shared by some Fed officials. San Francisco Fed President Janet Yellen said in a June 30 speech to the Commonwealth Club of California that the “predominant risk” is that inflation will “be too low, not too high, over the next several years.”

Inflation excluding food and energy may fall to about 1 percent over the next year and remain below 2 percent, with an unlikely possibility of turning into deflation if the economy fails to recover soon, Yellen said.

Another Fed district bank president, Charles Evans of Chicago, told reporters in London on July 1 that he also sees inflation falling “a bit from where we are now.”

“I don’t worry about the technical ability of the Fed to do it,” Martin Feldstein, a professor of economics at Harvard University, said in a Bloomberg Radio interview July 1. “What worries me is the political hurdle that they would be facing.” Congress won’t “easily” digest the Fed’s desire to limit lending and restrict inflation, Feldstein said.

To contact the reporters on this story: Scott Lanman in Washington at slanman@bloomberg.net; Steve Matthews in Atlanta at smatthews@bloomberg.net.

Last Updated: July 7, 2009 00:01 EDT