UPDATE 1-El-Erian: Fed to 'engage again' in Treasury buys

(Adds background and El-Erian quotes on bond yields)

By Jennifer Ablan and Daniel Burns

NEW YORK, June 12 (Reuters) - The rapid rise in bond yields will force the Federal Reserve to "engage again" in the purchases of U.S. Treasuries and mortgage-backed securities, Mohamed El-Erian, the chief executive of bond giant Pacific Investment Management Co., said Friday.

The surge in Treasury yields is lifting mortgage rates, threatening to dampen home demand and kill off the refinancing boom that is bolstering the health of some households.

"What mistake can the U.S. economy afford to make? If you look at it that way, I suspect that we will see the Fed engage again in these markets," El-Erian told Reuters Financial Television.

Debate is brewing within the Federal Reserve over whether it should ramp up its purchases of Treasuries and mortgage-backed securities to keep a lid on interest rates, or scale them back to avoid an outbreak of inflation.

Massive buying of securities by the U.S. central bank has doubled the size of its balance sheet to around $2 trillion as it flooded the economy with money to prevent a severe recession getting worse.

Fed chairman Ben Bernanke recently commented on the rise in U.S. long-term interest rates, remarking that it appeared to reflect "concerns about large federal deficits but also other causes."

El-Erian argues that the Fed will have to keep a lid on bond yields as the United States still faces major headwinds including a fragile labor market. He expects the unemployment rate could reach between 10 percent and 10 1/2 percent.