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Former Fed leader sees market-rattling infighting at central bank

NEW YORK, May 4 (Reuters) - After an extended period of relative peace among members of the U.S. Federal Reserve's interest rate policy-making committee, fireworks will erupt in coming months as they debate how to reduce the central bank's multi-trillion-dollar balance sheet, a former vice-chairman of the central bank said on Sunday.

"The Fed may get more raucous about what to do next as tapering draws to a close," Alan Blinder, a banking industry consultant and economics professor at Princeton University said in a speech to the Investment Management Consultants Association in Boston.

The cacophony is likely to "rattle the markets" beginning in late summer as traders debate how precipitously the Fed will turn from reducing its purchases of U.S. government debt and mortgage securities to actively selling it.

The Open Market Committee will announce its strategy in October or December, he said, but traders will begin focusing earlier on what will happen with rates as some members of the rate-setting panel begin openly contradicting Fed Chair Janet Yellen, he said.

The Fed built up its balance sheet over the last five-and-a-half years as it bought securities to lower interest rates in attempts to stimulate the weak economy.

But hawkish members of the Federal Open Market Committee who worry about inflation, such as Federal Reserve Bank of Dallas President Richard Fisher and Philadelphia Fed Bank President Charles Plosser, are likely to call for aggressive sales and contradict plans by Yellen and other doves in the majority who want to keep rates low as long as unemployment continues at high levels, Blinder told the group of stockbrokers and investment advisers.

Blinder, a supporter of Yellen who served on President Bill Clinton's Council of Economic Advisers in the mid-90s, said the "perils of a big balance sheet are not so horrible."

The Fed held only about $900 million on its balance sheet before Lehman Brothers' collapse in 2008 triggered the financial crisis, but will "never go back there" from its current level of about $4.25 trillion, Blinder said.

A balance sheet of $1.5 to $2 trillion will likely be the new normal, he said.

He congratulated Yellen on artfully backing away from former Fed Chairman Ben Bernanke's assertion that rates can begin rising once the U.S. unemployment rate hits about 6.5 percent.

The Federal Funds rate that determines short-term interest rate will not rise anytime soon, Blinder said, noting guidance from Yellen that she is watching several indicators of the economy.

The housing market, consumer spending and other parts of the U.S. economy are still recovering very slowly, said Blinder, adding that it will be six to 12 months after the Fed completely stops purchasing securities before rates start to rise.

He characterized the economy in this year's first quarter as "catastrophically bad," in part because of the fierce winter.

Economists forecasting a 4 percent quarterly growth rate this year are overly optimistic, said Blinder, who expects growth to continue at the sluggish rate of 2.25 percent that it has moved for the last few years.

When the Fed does begin to sell some of its securities, rates will go up faster than they fell during its periods of "quantitative easing," creating an overreaction from the markets that will need to be corrected, he said.

Asked after his talk how retail investors can prepare for the coming market volatility he is predicting, Blinder shrugged and said, "They can't."

(Reporting By Jed Horowitz; Editing by Kim Coghill)