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Fed leaders meet as U.S. economic recovery loses steam

By Neil Irwin
Washington Post Staff Writer
Tuesday, August 10, 2010; A10

As Federal Reserve policymakers meet Tuesday, they will face the challenge of a faltering economic recovery without a clear consensus on what, if anything the central bank should do about it.

Fed leaders still think that the recovery is on track, though the pace of growth has slowed and the risks of a dip back into recession have risen since their last policymaking meeting in late June.

That should be enough to at least get members of the Federal Open Market Committee to discuss their options for boosting the economy when they meet behind closed doors Tuesday -- including purchasing Treasury bonds or other assets, lowering the interest rate on bank reserves, or pledging to keep interest rates low for longer -- even if, as Fed-watchers expect, they won't pull the trigger on any of them.

There is a confusing menu of possibilities of what the Fed will do, and the committee's decisions will be announced Tuesday afternoon. Here's an overview of them -- including outcomes that are near-certain, some that could happen but aren't necessarily likely, and others that are unlikely.

Near-certain

The statement accompanying the Fed's policy announcement will very likely indicate a more subdued economic outlook than the one issued after the June 22-23 meeting, when the officials said that the "economic recovery is proceeding" and the labor market "improving gradually." Since then, there have been two straight weak jobs reports, new evidence that both industrial output and retail sales are growing more slowly, and disappointing data on second-quarter growth.

Look for the policymakers' statement to acknowledge that softness and echo Fed Chairman Ben S. Bernanke's view that the outlook is "unusually uncertain."

They are also likely to make clear that they stand ready to take further action to support the economy and prevent deflation, should conditions warrant -- language that is itself meant to instill confidence in the expansion.

Just maybe

The big question is whether Fed officials, having adjusted their outlook, will follow it up with any substantive action. This debate comes down to two questions: Will the action be effective at propping up encouraging growth and reducing the risk of deflation? And, even if it doesn't have a direct effect, will it at least signal to financial markets that the Fed is in a more accommodative mood?

One key option on the table will be to state that the Fed will maintain the current size of its balance sheet, $2.3 trillion, by buying new assets as the mortgage-backed securities in its portfolio mature. That would have only a moderate impact in terms of increasing the money supply, but would signal that the Fed has become more worried about growth.

Similarly, the Fed could strengthen its statement that economic conditions "are likely to warrant exceptionally low levels of the federal funds rate for an extended period." The policymakers could state how long an "extended period" might be, such as two or three years. Another aggressive change would be to state that low interest rates are likely to be warranted until certain economic conditions are met, such at an 8 percent unemployment rate or core inflation above 2 percent.

Another possibility would be to cut the interest rate on the excess reserves that banks park at the central bank, currently at 0.25 percent, to zero. This would technically be a decision of the Fed's Board of Governors, not the full FOMC, (although Bernanke, given his collaborative style, will surely allow an airing of the debate at the FOMC). The question they will ponder is whether the technical problems this action would create in the money markets would be worth the very modest benefits it creates for the economy.

One more possibility: Eric Rosengren, president of the Federal Reserve Bank of Boston, could dissent from the Fed's decision, calling for more aggressive intervention to support growth. And Thomas Hoenig, president of the Kansas City Fed, who has been calling for tighter monetary policy, could well choose not to dissent for the first time this year. If one or both men change direction, it would be a clear signal that sentiment on the committee has shifted.

Unlikely

Never say never, but a new, large-scale program of asset purchases known as quantitative easing does not appear to be on the table. Rosengren and a handful of other members may be open to such a move, but the center of the committee, including Bernanke, is skeptical that such steps would pack enough of an economic punch to be worth the risk of an inflation problem down the road, or of fears that the Fed is monetizing the debt, or printing money to fund deficits.

If Bernanke and company were to change direction and announce new asset purchases in the hundreds of billions of dollars, it would be a surprising outcome -- and likely reflect a "risk management" approach. Under that approach, while a dip back into recession and toward deflation would be considered unlikely, such an outcome would be so disastrous that the Fed should take aggressive steps to head off even the risk.

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