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UPDATE 1-Economists warn of more market 'tantrums' as U.S. Fed tightens

NEW YORK, Feb 28 (Reuters) - Financial market turbulence will likely return when the Federal Reserve decides to hike interest rates, top U.S. economists said in a paper that warns of the potential consequences of the Fed's extraordinary stimulus program.

The paper, released on Friday, focused on a financial market selloff in mid-2013 after Fed officials said they planned to trim monthly bond-buying. The authors argued that investors in mutual funds, though unleveraged relative to banks, showed signs they could destabilize markets in a rush to sell. This amounts to a hidden risk for the Fed, as central bank monitoring of financial market stability sometimes focuses on the degree to which trades are based on borrowed money.

The paper questioned whether the central bank was successful in mid-2013 in explaining its true intentions to the public, and thus was able to prevent further bouts of selling, as some Fed policymakers contend. It also suggested the economy faces bigger risks the longer the Fed keeps rates near zero.

"Whenever the decision to tighten policy is made, then the instability seen in summer of 2013 is likely to reappear," wrote JPMorgan chief U.S. economist Michael Feroli, Anil Kashyap, a professor at The University of Chicago Booth School of Business, both former Fed officials, and two other well-respected economists.

They cited as supporting evidence the turbulence earlier this year in the currencies and stocks of Turkey, Argentina and other emerging economies, which also depressed U.S. equities.

The paper, also co-authored by Princeton University professor Hyun Song Shin and Kermit Schoenholtz of New York University, was presented at a high-profile economics conference.

Several top Fed officials attended the conference, and Fed Governor Jeremy Stein agreed that the behavior of asset managers needs careful watching. He flagged the rapid growth fixed-income funds and similar investment funds.

"It would be a mistake to be complacent about this phenomenon simply because such funds are unlevered," Stein said.

After more than five years of ultra-accommodative policies in the wake of the recession, the Fed is taking the first steps to wind them down. It modestly trimmed a bond-buying program in each of the last two months, and it plans to raise rates some time next year, as long as the economy continues to improve.

Interest rates have been near zero since the worst of the financial crisis in late 2008. The Fed has meanwhile swollen its balance sheet to more than $4 trillion in a further attempt to stimulate investment, hiring and growth.

Fed policymakers are wary however that their stated plans for future policy actions, known as forward guidance, can cause borrowing costs to soar.

In May, after then Fed Chairman Ben Bernanke told a congressional hearing that the asset purchases could be tapered in "the next few meetings," the yield on the 10-year U.S. Treasury bond jumped from 2.04 percent to 2.54 percent over a month.

'NOT A FREE LUNCH'

The risk that all this easy money could bring about financial instabilities has stoked debate within the Fed over whether policymakers should stand ready to raise rates earlier than planned to snuff out those risks.

Daniel Tarullo, a Fed governor and its top bank regulator, said on Tuesday the central bank should not rule out using monetary policy to combat asset price bubbles that potentially threaten financial stability.

Minneapolis Fed President Narayana Kocherlakota, who has argued forcefully for easy money policies and was also present at the conference on Friday, acknowledged that policymakers may need to take financial stability risks into account when making policy.

But he stopped short of saying that such risks should keep the Fed from doing whatever it can to return the economy more quickly to full employment.

In the paper, the economists concluded that the current policy stimulus "is not a free lunch" and can bring about disruptions when that accommodation is lifted.

"Perhaps the domestic macroeconomic fallout from exit will be as gentle as was the impact from the 2013 'taper tantrum,"' they wrote. "However, such a benign outcome is not guaranteed: while tapering is now under way, monetary policy remains highly accommodative, so a meaningful exit has yet to occur."

Standing back, the economists argue that the Fed's two key stimulus efforts, the bond buying and the forward guidance, "can build future hazards by encouraging certain types of risk-taking that are not easily reversed in a controlled manner."

The paper also underlines a concern that Tarullo and Stein have raised in the past: that regulatory tools may not be enough to stamp out risks in harder-to-detect corners of financial markets.

The usual tools of monitoring banks - bank capital ratios and liquidity requirements, among other regulations - fail to address instabilities that mutual fund investors, for example, can cause when they rush for the exits, the economists wrote.

The 55-page paper examined bond flows from mutual funds, and noted that investors do not want to be the last out of a trade.

It finds that banks need not take action to spark market tantrums, suggesting that too-big-to-fail banks should not be the sole focus of regulators looking to stabilize markets.

The "absence of leverage may not be sufficient to ensure that monetary policy can disregard concerns for financial stability," the paper said.