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By Mark Felsenthal and Alister Bull
WASHINGTON, May 20 (Reuters) - The Federal Reserve said on Wednesday it saw modest improvements in the U.S. economy last month, but it still saw big risks and left open the possibility of increasing its purchases of mortgage-related and government debt to keep credit flowing and spur recovery.
Despite a pickup in household and business confidence that Fed officials saw helping to steady spending when they met in late April, they viewed the evidence as too tentative to erase risks facing the recession-mired economy.
The policy-makers cut their forecasts for economic growth over the next three years and debated whether they should further ramp up planned purchases of mortgage agency and government securities, minutes of their April 28-29 meeting said.
The Fed in recent months has turned to asset purchases as a means to keep credit flowing since running out of scope to further lower benchmark interest rates after bringing them down to close to zero percent last year.
"Some members noted that a further increase in the total amount of purchases might well be warranted at some point to spur a more rapid pace of recovery," the minutes of the Federal Open Market Committee's meeting said.
"All members concurred with waiting to see how the economy and financial conditions respond to the policy actions already in train before deciding whether to adjust the size or timing of asset purchases," they added.
In fresh quarterly forecasts, the Fed projected the U.S. economy would contract by between 1.3 percent and 2.0 percent this year, with the unemployment rate rising to between 9.2 percent and 9.6 percent.
In January, the Fed had forecast a milder contraction of between 0.5 percent and 1.3 percent, with the jobless rate rising to between 8.5 percent and 8.8 percent. [FED/FCAST]
U.S. stocks fell on the gloomier economic forecast, while debt prices rallied on the prospect the Fed could boost its securities purchases.
"The tone of the minutes is a little more optimistic, and the forecasts are a little more pessimistic," said Christopher Low, chief economist for FTN Financial in New York.
The minutes showed the Fed staff last month had offered a sunnier forecast than the policy-makers, with the staff revising up their outlook for economic activity. They anticipated that growth would expand at a rate well above its potential in 2011 and that the unemployment rate would decline significantly. [FED/FCAST1]
"Key factors expected to drive the acceleration in economic activity were the boost to spending from fiscal stimulus, the bottoming out of the housing market, a turn in the inventory cycle from liquidation to modest accumulation, and ongoing gradual recovery of financial markets," the minutes said.
DEFLATION RISKS SUBDUED
At its April meeting, the Fed held its target for its benchmark federal funds interest rate unchanged at close to zero, the level reached in December, and took no other actions to boost the amount of money in the economy.
A month earlier, it had shocked financial markets by expanding purchases of mortgage agency securities and debt by $850 billion and pledging to buy $300 billion of longer-term Treasury securities over the next six months, the first time since the 1960s it has bought Treasuries.
The minutes said inflation looked to remain subdued, and many officials at the meeting also felt the danger had diminished that the United States would suffer a Japan-style deflation of widespread and lasting price declines.
"The combination of green shoots in the economy, some easing of financial market conditions, and less deflation risk or even some inflation risks, apparently reassured the (policy) committee that the economy is on the right track," UniCredit Markets & Investment Banking economist Harm Bandholz wrote in a note to clients. (Editing by Leslie Adler)