Jan. 28 (Bloomberg) -- The Federal Reserve left the benchmark interest rate as low as zero, said it’s prepared to purchase Treasury securities to resuscitate lending and warned inflation may recede too quickly.

The Fed is ready to buy “longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets,” the Federal Open Market Committee said in a statement today in Washington. Any purchases before the FOMC’s next meeting in March would still need a vote to authorize the action.

Chairman Ben S. Bernanke, by making emergency credit programs rather than rates the focus of policy, is quelling some of the panic in markets while failing to revive growth. Falling home prices, rising unemployment and more than $1 trillion in losses and writedowns at global financial institutions are deepening the longest recession since the 1980s.

“The focus of the committee’s policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve’s balance sheet at a high level,” the Fed said in the statement.

Treasury notes declined after the Fed stopped short of announcing it would begin the purchases. The yield on the benchmark 10-year note climbed about 13 basis points to 2.65 percent at 4:30 p.m. in New York. Stocks rose, with the Standard & Poor’s 500 Index increasing 3.4 percent to 874.09 in New York.

Too Little Inflation

The Fed said there is a risk that inflation could fall too low. “The committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term,” the statement said.

The Fed’s preferred inflation gauge, the personal consumption expenditures price index, excluding food and energy, may rise just 0.78 percent this year, according to Macroeconomic Advisers LLC in St. Louis. That’s about 1 point below the preference range that policy makers signaled in their third-year forecasts in January 2008.

“Deflation is an increased worry,” said William Ford, a former Atlanta Fed chief who’s now at Middle Tennessee State University in Murfreesboro. “They have switched from worrying about inflation to being focused on deflation. It is the first time they have talked about that in a straightforward way.”

Richmond Federal Reserve Bank President Jeffrey Lacker dissented from today’s decision. He preferred to expand the “monetary base at this time by buying Treasuries rather than through targeted credit programs.”

As ‘Conditions Warrant’

The central bank also said it’s ready to expand the quantity of its purchases of mortgage-backed securities and agency bonds and lengthen the program “as conditions warrant.”

The purchase of Treasuries would extend the Fed strategy of using its balance sheet to reduce borrowing costs. The new program may benefit several types of borrowers, because long-term government bond yields influence interest rates on mortgages, corporate bonds and municipal debt.

The Fed would also be lowering federal financing costs as the government ramps up deficit spending. Treasuries declined 1.6 percent this month, the worst monthly return since April, eroding a 14 percent gain in 2008 that was the most in 13 years, Merrill Lynch & Co. indexes show.

Federal Debt

Investors are anticipating a large increase in the supply of debt to help finance President Barack Obama’s fiscal stimulus plan, which administration officials estimate at $825 billion.

The risk is that turning government deficits into money can spur an increase in prices.

“There is a lot of concern the Fed balance sheet has risen so quickly and so much and it creates an inflation risk down the road,” said John Silvia, chief economist at Wachovia Corp. in Charlotte, North Carolina, and a former congressional staff economist.

The Fed clashed with the Treasury in the 1950s by reasserting its independence as an inflation fighter after helping the government finance the costs of World War II.

“The Fed should have an accord by which it has some push- back capacity,” former Richmond Fed policy adviser Marvin Goodfriend said before the announcement.

“It is the exit strategy that you have to worry about to make this policy credible,” said Goodfriend, a professor at the Tepper School of Business at Carnegie Mellon University in Pittsburgh.

Fed’s Assets

The Fed’s assets have grown by $1 trillion over the past year under credit programs ranging from $416 billion in term loans to banks to purchases of $350 billion in commercial paper issued by U.S. corporations. The balance sheet will continue to grow under plans announced by the central bank.

“The Fed has pulled out all the stops,” Paul McCulley, a managing director and fund manager at Pacific Investment Management Co. in Newport Beach, California, said in an interview before the announcement. “The Fed’s mission has to be to bring down private-sector borrowing rates.”

Bernanke, a scholar of the Great Depression, criticized the Fed in December for failing to stop bank failures that inflamed panic in financial markets during the 1930s. The former Princeton University economist views financial stability as a prerequisite for an economic recovery.

The Fed Board has supported bailouts of Bank of America Corp. and Citigroup Inc. by offering a layer of protection against losses on troubled assets. The Federal Deposit Insurance Corp. and U.S. Treasury also back the rescues.

Policy Goal

“For now, the goal of policy must be to support financial markets and the economy,” Bernanke said at the Dec. 1 speech in Austin, Texas.

The Fed announced Nov. 25 that it would buy $600 billion in housing agency bonds and mortgage-backed securities they guarantee. The bond purchases will expand money in the banking system. Excess bank reserves averaged $843 billion in the first two weeks of January, an increase from $1.64 billion for the same month a year earlier.

Next month, the Fed plans to launch the $200 billion Term Asset-Backed Securities Loan Facility, which will buy bonds backed by newly issued consumer and small-business loans. The program can be expanded to include other assets.

There are some signs that the Fed’s action has begun to thaw credit markets. Sales of commercial paper totaled $1.69 trillion last week, up from October’s low of $1.45 trillion, though down from $1.76 trillion in the first week of the year.

Borrowing Costs

The cost of borrowing dollars in London for three months rose to a two-week high this week as confidence in the banking system weakened. The London interbank offered rate, or Libor, for three-month loans slipped 1 basis point to 1.17 percent today, according to British Bankers’ Association data.

Libor had surged to 4.82 percent on Oct. 10 as credit froze following the bankruptcy of Lehman Brothers Holdings Inc. The TED spread, the difference between what the U.S. government and companies pay for loans for three months, was unchanged at 105 basis points. The spread was 464 basis points on Oct. 10.

U.S. employers slashed 2.6 million jobs last year, the most since 1945, pushing the unemployment rate up to 7.2 percent in December. Home prices in 20 U.S. cities declined by 18.2 percent in November from a year earlier, the fastest drop on record, according to the S&P/Case-Shiller index.

Gross domestic product probably contracted at a 5 percent annual rate from October through December, the biggest drop since 1982, according to the median estimate in a Bloomberg News survey ahead of Commerce Department figures due on Jan. 30.

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net

Last Updated: January 28, 2009 16:43 EST