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From the past week:

(1) Foreigners cut Treasury stakes; rates could rise

Foreign demand for short-term Treasuries tumbles, led by China; chance of higher rates looms

Martin Crutsinger and Bernard Condon, AP Business Writers, On Tuesday February 16, 2010, 5:12 pm EST

WASHINGTON (AP) -- A record drop in foreign holdings of U.S. Treasury bills in December sent a reminder that the government might have to pay higher interest rates on its debt to continue to attract investors.

China reduced its stake and lost the position it's held for more than a year as the largest foreign holder of Treasury debt. Japan retook the top spot as it boosted its Treasury holdings.

The Treasury Department said foreign holdings of U.S. Treasury bills fell by a record $53 billion in December. That topped the previous record drop of $44.5 billion in April 2009.

Private analysts, though, were split over the significance of the decline. Some doubted that the drop in foreign holdings of short-term Treasuries signified growing unease about holding U.S. debt. They noted that net purchases of longer-term Treasury debt rose in December by $70 billion.

But other economists saw the decline as a warning signal. They fear that foreigners, especially the Chinese, have begun to worry about record-high U.S. budget deficits and are looking to diversify their holdings.

A sustained drop in foreign demand for dollar-denominated assets could lead to higher U.S. interest rates and falling stock prices. Those trends could threaten the U.S. recovery. But economists said they see no such evidence yet.

The Treasury report showed that China reduced its holdings of Treasury securities by $34.2 billion in December.

Alan Meltzer, an economics professor at Carnegie Mellon University, said China's shift should be a wake-up call for Washington.

"The Chinese are worried that we have unsustainable debt levels, and we do not have a policy for dealing with it," Meltzer said.

He said the Chinese worry that confidence in the U.S. government's ability to repay its debt could erode. That would cause the value of Treasuries and the dollar to fall -- and lead to losses on Beijing's' U.S. debt holdings.

The Obama administration on Feb. 1 released a budget plan that projects the deficit for this year will total a record $1.56 trillion. That would surpass last year's record of $1.4 trillion deficit.

The recession helped drive up the deficits. Tax revenue fell as the economy slowed. And spending undertaken to support the economy and stabilize the financial system worsened the budget gaps.

The administration has pledged to address the budget gaps. President Barack Obama has said he will appoint a commission to recommend ways to trim future deficits. But China and others have expressed doubts about the commitment of the United States to reduce the red ink.

Moody's Investors Service has warned that the U.S. government's top credit rating could be jeopardized if the nation's finances don't improve. Asked about this report, Treasury Secretary Timothy Geithner said this month he was confident the United States "will never" loose its sterling credit rating. He predicted foreigners would keep buying U.S. Treasurys as a safe investment.

Some private economists warned against reading too much into December's drop in foreign purchases of short-term Treasury debt. They noted that the figures are volatile from month to month. They also pointed out that Europe's debt crisis has put pressure on the euro and boosted demand for U.S. Treasurys and the U.S. dollar.

"China may not be too happy with us right now, but you have to ask, what else are they going to do with their money?" said David Wyss, chief economist at Standard & Poor's in New York.

The Treasury International Capital report showed that net foreign demand for long-term securities totaled $63.3 billion in December. This figure includes Treasury debt, debt of government sponsored enterprises such as Fannie Mae and Freddie Mac as well as the bonds sold by private corporations and private company stock.

John Taylor, chairman of hedge fund FX Concepts, predicted that the drop in short-term Treasury holdings would likely be reversed in coming months. In part, he thinks that's because the euro, the main alternative to the dollar, has fallen about 10 percent against the U.S. currency since mid-January.

For December, Japan boosted its holdings of Treasuries by $11.5 billion to $768.8 billion. That figure exceeded China's December total of $755.4 billion and restored Japan's position as the largest foreign owner of Treasuries.

The $53 billion decline in holdings of Treasury bills came primarily from a drop in official government holdings. They fell by $52.3 billion. Holdings of foreign private investors dropped by $700 million in December.

For all of 2009, foreign holdings of U.S. Treasury bills dipped by $500 million. In 2008, foreigners had increased their holdings of short-term U.S. Treasuries by $456 billion. That occurred as a global financial crisis triggered a flight to the safety of U.S. government debt. As a result, the rates the government was paying on its debt fell to record lows. Rates on some short-term securities sank into negative territory for brief periods.

China's holdings are a result of the huge trade deficits the United States runs with China. The Chinese take the dollars Americans pay for Chinese products and invest them in Treasury securities and other dollar-denominated assets.

(2) Fed Official Warns: Inflation Is Hard to Avoid

The ballooning U.S. budget deficit and growing mountains of federal debt will increase pressures on the Fed to hold interest rates low and make it harder to avoid inflation, a senior Federal Reserve official said on Tuesday.

"The current outlook for fiscal policy poses a threat to the Federal Reserve's ability to achieve its dual objectives of price stability and maximum sustainable long-term growth, and therefore is a threat to its independence as well," Kansas City Federal Reserve President Thomas Hoenig said in remarks prepared for delivery to the Peterson-Pew Commission on Budget Reform.

Fiscal policymakers should opt for the difficult path of cutting spending and increasing revenues in order to rein in deficits, Hoenig said.

U.S. fiscal policy must focus on reducing the debt buildup and its consequences, he said.

A debt rating agency said earlier this month that high U.S. budget deficits could put the country's top-level debt rating at risk.

While the Obama administration's recently announced budget proposal would take a small step toward sustainable debt levels, more is needed to preserve the country's Aaa rating, Moody's Investors Service said.

Hoenig also said the suggestion by economists at the International Monetary Fund that central banks tolerate higher levels of inflation than they have in the past to gain more power to counteract economic shocks is worrisome and would send the economies down the wrong path.

An IMF staff paper released on Friday suggested that policymakers might consider raising their inflation target to 4 percent from 2 percent to allow monetary policy to be more effective in future deflationary crises.

The Kansas City Fed president, who is a voter this year on the Fed's interest rate-setting panel, said high debt will tempt politicians to push the Fed to print money to bridge budget shortfalls.

Such an approach has historically led to "major inflation," Hoenig said.

The Fed pumped more than $1 trillion into the U.S. economy to continue to help the economy after it had cut interest rates to near zero.

Many - including Hoenig - worry the massive amount of cash in the financial system will fuel runaway inflation when the economic recovery gains strength.

The Fed has said the weak economy needs the support of low rates and a financial system flush with money and that it has the tools to remove those supports when economic growth gains traction.

Hoenig dissented in January against the Fed's decision to continue to promise that it would hold interest rates exceptionally low for an extended period.

Hoenig said he believes the economy has recovered sufficiently for the Fed to remove that pledge.

(3) Lone voice warns of debt threat to Fed

The US must fix its growing debt problems or risk a new financial crisis, Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, warned on Tuesday, adding a mounting deficit could spur inflation.

Mr Hoenig said that rising debt was infringing on the central bank's ability to fulfill its goals of maintaining price stability and long-term economic growth. "Stunning" deficit projections were putting political pressure on the Fed to keep interest rates low, infringing on its independence at the risk of inflation, he said.

"Without pre-emptive action, the US risks its next crisis," Mr Hoenig said in a speech at the Pew-Peterson Commission on Budget Reform.

He was the only Fed member who dissented at last month's meeting against language indicating that interest rates should remain near zero for an "extended period".

On Tuesday he said that the worst option for the US was a scenario where the government "knocks on the central bank's door" and asks it to print more money. Instead, the administration must find ways to cut spending and generate revenue. He called for a "reallocation of resources" and noted that the process would be painful and politically inconvenient.

The US budget deficit is projected to be $8,000bn (EUR 5,800bn, GBP 5,000bn) in the next decade. Barack Obama, US president, recently lifted the government's borrowing authority to $14,300bn.

If the Fed succumbed to pressure to increase the money supply, Mr Hoenig said, inflation would lead to a loss of confidence in the dollar and in the economy. Meanwhile, a potential stalemate between the fiscal and monetary authorities that govern the economy could allow growing imbalances to go unchecked, thus raising the costs of borrowing and of capital for the US.

The hawkish Kansas Fed president also warned against "dire" consequences of the central bank prolonging its holdings of mortgage-backed securities, which it purchased in an effort to prop up the US housing market. Mr Hoenig painted a picture of a slippery slope, where a less independent Federal Reserve was asked to find ways to support other ailing sectors, such as agriculture.

The Federal Reserve is purchasing $1,250bn in MBS through March. Mr Hoenig said that it must shrink its balance sheet as quickly as possible while being careful and systematic.

Being pulled into the political framework has complicated the Fed's job, which Mr Hoenig said should remain focused on the Fed funds rate and price stability.

Holding tightly to the notion of Fed independence, he rejected a suggestion published in a paper by Olivier Blanchard, chief economist at the International Monetary Fund, that central banks should set higher inflation targets. He also said he hoped to avoid political pressure to restore quantitative easing policies.

"That's when independence will be more important than ever," he said.

(4) Deficit to Explode with Obama's Spending Plans Even with Recovery

It's bad enough that Greece's debt problems have rattled global financial markets. In the world's largest economic and military power, there's a far more serious debt dilemma.

For the U.S., the crushing weight of its debt threatens to overwhelm everything the federal government does, even in the short-term, best-case financial scenario - a full recovery and a return to prerecession employment levels.

The government already has made so many promises to so many expanding "mandatory" programs. Just keeping these commitments, without major changes in taxing and spending, will lead to deficits that cannot be sustained.

Take Social Security, Medicare and other benefits. Add in interest payments on a national debt that now exceeds $12.3 trillion. It all will gobble up 80 percent of all federal revenues by 2020, government economists project.

That doesn't leave room for much else. What's left is the entire rest of the government, including military and homeland security spending, which has been protected and nurtured by the White House and Congress, regardless of the party in power.

The U.S. debt crisis also raises the question of how long the world's leading power can remain its largest borrower.

Moody's Investors Service recently warned that Washington's credit rating could be in jeopardy if the nation's finances didn't improve.

Despite election-year political pressure from voters for lawmakers to restrain spending, some recent votes suggests that Congress, left to its own devices, probably isn't up to the task of trimming deficits.

Both the Obama administration and Democratic leaders have put job creation ahead of deficit reduction for now.

The Senate faces an important vote after it returns on Feb. 22 from its President's Day recess on a bill intended to stimulate job growth. The legislation offers a $13 billion payroll tax credit for companies that hire unemployed workers, including an additional $1,000 tax credit for workers retained for a full year.

Proposed belt-tightening steps by President Barack Obama, including a freeze on some nondefense, nonentitlement spending, would make only a small dent in the mountain of debt.

The budget he submitted to Congress this month proposes record spending of $3.8 trillion for 2011. Taxes in next year's budget will support only $2.5 trillion of that spending, leaving $1.3 trillion to be borrowed.

The president's budget is a best-case outlook, from the administration's vantage point.

It doesn't take into account future liabilities from the growth of entitlement benefits and is based on projected economic growth that depends on a solid recovery. It assumes Congress will pass all of Obama's initiatives, including spending cuts and tax increases previously rejected by Congress.

Congress already has rejected a bipartisan deficit commission that could have forced Congress to take painful steps on tax increases and entitlements.

The commission would have been modeled on one that makes military base-closing decisions, forcing Congress to take up or down votes. The Senate turned aside the legislation last month after some original Republican supporters jumped ship once Obama endorsed the plan.

Proponents say this type of commission is the only way to make painful debt decisions. Obama says he'll create a bipartisan commission by presidential order instead.

"In the end, solving our fiscal challenge - so many years in the making - will take both parties coming together, putting politics aside, and making some hard choices about what we need to spend, and what we don't," Obama said in his weekly Saturday radio and internet address.

Still, his commission wouldn't have the power to force a congressional vote.

Obama's call for fiscal austerity came at the same time he signed legislation lifting the cap on government debt from $12.4 trillion - which is close to being breached - to $14.3 trillion to permit more borrowing.

The same law puts in place new budget rules praised by deficit hawks that would require future spending increases or tax cuts to be paid for with higher taxes or other spending cuts. "After a decade of profligacy, the American people are tired of politicians who talk the talk but don't walk the walk when it comes to fiscal responsibility," Obama said.

It's not clear when the debt's day of reckoning will arrive. But the overall national debt over the next few years will rise to 100 percent of the gross domestic product - a level viewed as alarming by the International Monetary Fund and international economists.

The Social Security system, the biggest social spending program, has begun paying out more in benefits than it collects in payroll taxes. For the past quarter-century, Social Security had produced a surplus that helped finance the rest of the government.

Medicare, the health care program that now covers 45 million elderly and disabled people, is in worse shape. It's been paying out more than it takes in since 2008 and its trust fund is projected to run out of money in 2017.

Carmen Reinhart, an economics professor at the University of Maryland and a former IMF official, suggested the nation's fast-growing indebtedness may not have a visible impact at this point on ordinary Americans. But some day it will pounce.

"One thing we can say with a fair amount of certainty," she said. "We never know when the wolf will be at our door. The wolf is very fickle and markets can turn very quickly. And a high debt level makes us very vulnerable to shifts in sentiment that we cannot predict."