* QE3 could total $1.7 trillion in bond buys, analysts say
* QE2 was $600 billion; QE1 was $1.75 trillion
* Disagreement remains on its ultimate impact
By Ann Saphir
CHICAGO, Sept 14 (Reuters) - The U.S. Federal Reserve's third round of bond-buying could ultimately rival the size of its first huge quantitative easing, which was widely seen as boosting growth.
The sheer scale of the program and the radical shift in policy it marks will shape the legacy of Fed Chairman Ben Bernanke, whose term may end before the buying is through.
The Fed initially disappointed some investors on Thursday when it said it would buy $40 billion of mortgage-backed securities each month. That is far less than the $75 billion a month it bought in its second round of bond-buying, or the more than $100 billion monthly tab for its first round.
But this time, the Fed has promised that "if the outlook for the labor market does not improve substantially," it won't stop buying and could ramp up its spending further.
Depending how the Fed defines "substantially" and how long it takes to get there, it could end up buying bonds for several years, adding $1.7 trillion or more to its balance sheet, analysts say.
By comparison, the Fed's initial round of quantitative easing, first announced in November 2008 as the U.S. economy slumped into a deep recession, totaled $1.75 trillion .
"They've clearly committed to do what it takes to get unemployment down where they want it," said Pierre Ellis, an economist at New York-based Decision Economics. "There's no limit."
To Ellis, the "big bazooka" of open-ended bond purchases -- designed to boost the economy by lowering borrowing costs -- won't have much immediate impact because the economy's main headwind is uncertainty over fiscal policy and the outcome of a presidential election.
That's a view shared by several of the central bank's hawkish members.
U.S. Treasuries sold off broadly on Friday and 10-year and 30-year debt yields rose to their highest levels since May as the new stimulus spurred risk-taking in stocks, reducing demand for bonds, and as bond investors feared inflation from the program.
Disappointment that Treasuries were not included in the central bank's third round of quantitative easing added to the selloff, traders said.
A rise in long-term yields runs counter to the goals of the program, which include pushing down long-term borrowing costs.
Bernanke, whose term ends in January 2014, sought on T hursday to tamp down worries that he is aiming for higher inflation, which is near the Fed's 2 percent target. The goal, he said, is to bring down unemployment, which at 8.1 percent is well above what most economists believe it should be.
Still, he acknowledged the possibility that the Fed could tolerate some period of higher inflation.
"If inflation goes above the target level, as we talk about in our statement in January, we take a balanced approach," he said at a press conference following the Fed's policy shift. "We bring inflation back to the target over time but we do it in a way that takes into account the deviations of both of our objectives from their targets."
Many analysts say the Fed's latest program may exceed its predecessors in size, and more importantly, also pack the desired punch.
"We believe that with a strong commitment from the Fed, progress in Europe and the passing of the U.S. election, the U.S. economy will have a pretty decent shot at achieving above-trend growth in 2013," Julia Coronado, an economist at BNP Paribas, wrote in a note to investors.
Thursday's announcement could add another $1.2 trillion to $1.7 trillion to the Fed's balance sheet, she said.
The Fed has kept short-term rates near zero since December 2008, and Fed Chairman Ben Bernanke has led the U.S. central bank into ever-newer territory to lower real rates further.
After the first round of bond-buying in 2008 and 2009, the Fed resorted in 2010 and 2011 to a second round to ward off deflation as the recovery faltered.
As he doubles down on quantitative easing, Bernanke's approach looks flexible enough to win support from both ends of the Fed spectrum - the doves who want more easing to bring down unemployment, and the hawks who worry that more easing could overheat the economy and spark inflation.
"Everybody likes tying it to economic conditions," said Paul Ashworth, chief U.S. economist at Toronto-based Capital Economics. He estimates the program could eventually grow to between $960 billion to $1.44 trillion in size.
"The doves like this because they think the markets will think it's even bigger" than QE2, he said. At the same time, "it gives the hawks something, that if the economy picks up, they can get this stopped."
The Fed did not say how big it expects its latest program to be, but the clues are plain in its quarterly economic forecasts, also published Thursday.
Only three Fed policymakers expect the unemployment rate, now at 8.1 percent, to fall more than half a percentage point by the end of next year.
If the Fed sees 7 percent as substantial progress, the forecasts suggest continued bond buying through late 2014; if a bit lower, bond-buying could be needed through mid-2015, Ashworth said. Underscoring that interpretation, the Fed said Thursday it expects to keep rates low until at least then.
Before the crisis, unemployment was closer to 5 percent.
Chicago Fed President Charles Evans has spent the last year arguing strongly for the Fed to tie monetary policy more closely to economic milestones by vowing to keep rates low until unemployment fell below 7 percent.
Doing so, he says, would avoid the temptation of backing off from easing at the first signs of economic strengthening. In a series of speeches in recent months, he has likened a strong Fed commitment to low rates to a modern-day Ulysses tied to the mast of his ship, prevented from responding to the siren call of premature monetary tightening.
While the Fed did not embrace Evans' 7-percent unemployment rate target, it did adopt his view that the Fed should hold fast to easy policy even after the recovery picks up speed -- a historic shift in policy.
Any eventual ceiling on the size of QE3 looks sky-high. The Fed may only buy Treasuries and agency-backed debt, and some Fed officials say it has bought nearly as much of the U.S. national debt as it can without impairing the market's function.
But with mortgage-backed securities, there is plenty room to run: economists estimate the size of that market at more than $7 trillion, although the Fed would need to avoid disrupting the market's function.
Michael Gapen, an economist at Barclays, sees QE3 topping out at $700 billion - slightly more than the second round of quantitative easing, but less than half the first.
The impact, he said, could be limited to boosting economic growth by a few tenths of a percentage point, although that could be enough to generate momentum.
"If you can keep the economy persistently above trend, then that has a self-reinforcing effect," he said.
Combined with the European Central Bank's vow to buy as many bonds as needed from euro zone states -- on condition they undertake reforms -- QE3 "has the potential to be very positive for the U.S. economy," Gapen said.
However, he said one real threat to the economy remains: a raft of tax increases and spending cuts that will automatically take effect at the end of the year unless Congress acts.
But if lawmakers successfully avoid the so-called fiscal cliff, the outcome for the economy could beat expectations and ultimately trim the size of QE3.