June 2 (Bloomberg) -- As if a slowing economy, a falling dollar, faster inflation and a credit crunch weren't enough headaches for U.S. Treasury Secretary Henry Paulson, he now has to worry that the Federal Reserve will undermine the return of the one-year bill.

For the first time since 2001, the government will sell 52- week debt tomorrow, expanding its source of funding as the budget deficit approaches a record. The Fed is selling Treasury bills at the fastest pace since it was founded in 1913 to support bank-lending programs meant to boost confidence in financial markets. The Fed owns $34.3 billion of the securities, down from $267 billion, or 27 percent of the market, in December.

``The Fed took a proportion of Treasury sales so regularly, so often, that we just took it for granted,'' said Stephen Van Order, a debt strategist in Bethesda, Maryland, at Calvert Asset Management, which oversees $10 billion in bonds. ``You do have to find buyers for the Treasuries that the Fed would have taken in the past. Bills, of course, have been torched by this.''

For every dollar the central bank adds to the banking system under the lending facilities, it withdraws a similar amount to maintain its target rate for overnight loans. The Fed bought bills at all but three of the 992 auctions from August 2001 to last December, according to the Treasury. By comparison, it didn't purchase bills at 30 of the 66 sales in the five months through April, and it won't buy any of those sold this week.

Rates Rise

Interest rates on six-month Treasuries, the longest maturity bill before the revival of one-year securities, have climbed 95 basis points since mid-March, touching a three-month high of 2.04 percent on May 29. The 4.875 percent Treasury due May 2009, which was issued a year ago, yielded 2.25 percent as of 8:20 a.m. in New York.

The Treasury will sell $16 billion of 52-week securities tomorrow. The government began regular sales of the one-year bill in 1959 and eliminated it in 2001 after the U.S. posted three straight yearly budget surpluses.

Now, President George W. Bush's administration forecasts the deficit will swell to $410 billion in the fiscal year ending Sept. 30, just shy of the record $413 billion set in 2004.

On top of that, the dollar has fallen 11 percent against a basket of six major currencies in the past year; inflation is rising at a 3.9 percent rate, almost double its pace in August; and U.S. financial firms have reported $162.5 billion in credit- market losses, Bloomberg data show.

`Double Whammy'

``Not only is total issuance increasing, but the percentage of total issuance going to non-Fed investors is increasing as well,'' said Michael Pond, an interest-rate strategist in New York at Barclays Capital Inc., one of the 20 primary dealers that trade with the Fed and are required to participate in Treasury auctions. ``And that's really a double whammy.''

In the first five months of 2008, the Treasury sold $1.4 trillion of bills, an increase of 36 percent from the same period last year. Paulson didn't return a message left with his spokeswoman.

The Fed boosted its sales this year as policy makers raised the size of the biweekly Term Auction Facility, which makes 28- day loans to commercial banks, to $75 billion from $20 billion; raised the amount of dollar transfers to foreign central banks to $62 billion from $24 billion; and made $220 billion in new 28-day cash loans to primary dealers.

The central bank also started making loans in March directly to securities firms through its discount window, and loaned $29 billion to New York-based JPMorgan Chase & Co. for its takeover of investment bank Bear Stearns Cos.

Permanent Access

Fed Vice Chairman Donald Kohn said May 30 that policy makers may want to continue the TAF even after markets stabilize and give securities firms permanent access to cash loans.

The New York Fed will sell or redeem at least $15 billion in bills, notes or bonds in the next month, said Michael Cloherty, an interest-rate strategist in New York at primary dealer Banc of America Securities LLC. The Fed's bills comprise 3.3 percent of the $1 trillion market, down from 27 percent in December.

After every Treasury auction, the central bank can exchange its maturing debt for new securities. The Fed said on May 29 that it would redeem all of its $3.4 billion of bills maturing this week, indicating it won't buy any of the debt auctioned tomorrow.

The Fed lends its holdings daily in order to manage bank reserves and carry out monetary policy. If the central bank doesn't own a given security, it may become riskier and more expensive for dealers to sell to other firms and investors.

`Not a Good Fit'

``It's going to be much more difficult for dealers to make markets if there's not a backstop source of supply,'' said Louis Crandall, chief economist at Wrightson ICAP, a Jersey City, New Jersey-based government finance research firm. ``They know that if they sell a security that they are unable to source in the market, they can also borrow it from the Fed. But if the Fed doesn't own it, then they have to be much more careful.''

David Glocke, who manages $33.1 billion of short-term securities at Vanguard Group Inc. in Valley Forge, Pennsylvania, doesn't plan to buy one-year bills for his money-market funds because he expects the Fed to stop lowering borrowing costs after seven cuts since September.

``It's not a good fit in an environment where interest rates may rise,'' he said. Plus, ``the fact that the Fed's been selling a lot of bills would imply maybe that there's less overall liquidity in the market because the Fed's reduced positions.''

To contact the reporter on this story: Sandra Hernandez in New York at shernandez4@bloomberg.net

Last Updated: June 2, 2008 08:23 EDT