By Neil Irwin
Washington Post Staff Writer
Wednesday, September 15, 2010; 8:33 PM
Chairman Ben S. Bernanke and his colleagues at the Federal Reserve are facing their biggest decision since the end of the financial crisis, confronting a fateful choice this fall whether to take new, exceptional steps to boost the flagging economic recovery.
These measures are likely to be the focus of a vigorous debate at a Fed policy meeting next week, setting the stage for a definitive decision in November or December on whether to purchase hundreds of billions of dollars of bonds in an effort to strengthen the economy. No action is likely at the policy meeting scheduled for Tuesday, which means monetary policy could remain in a holding pattern until the Fed committee reconvenes later in the fall.
Fed policymakers face two major questions: Will the weak economic recovery of the past few months persist through 2011? And would pumping vast new sums of money into the economy pack enough punch to be worth the risks?
Top Fed officials will be preparing formal forecasts for the economy over the coming years in advance of their meeting Nov. 2 and 3. If their consensus is that growth will be too slow next year to bring down the unemployment rate significantly, they will be more inclined to take action, even if the exact economic impact is modest and hard to predict, according to analysts who study the Fed.
The sluggishness of the recovery was underscored Wednesday as the Fed reported that industrial production rose only 0.2 percent in August. After the U.S. economy recorded a weak 1.6 percent growth rate in the second quarter, forecasters say they expect a similar result in the third quarter, which ends Sept. 30.
If the Fed resumes bond purchases - or as economists call it, "quantitative easing" - it would support the economy by lowering long-term interest rates, such as for mortgage loans and business loans to finance investment. But this course carries risks - for instance, stoking inflation and giving investors the dangerous perception that the Fed will readily print money to fund U.S. budget deficits.
As the debate over further bond purchases has ripened within the central bank and among outside economists, many Fed watchers expect action before the end of the year unless economic data improve significantly.
"At some point, they're probably going to be looking at a forecast in which they're not making substantial progress bringing down the unemployment rate," said Michael Feroli, senior economist at J.P. Morgan Chase. "It's far from a done deal, but more easing seems more likely than not at some point later this year."
Economists at the central bank are undertaking a new round of analysis on the likely impact of such moves and confronting questions for which the answers are anything but obvious.
For example, Fed analysts are exploring whether new bond purchases can do much to lower interest rates, because they are already extremely low.
Fed officials are also weighing whether lower rates would spur business investment. Businesses, especially larger ones, already have access to very cheap credit with which to invest and hire, but few are taking the opportunity.
Among the possible benefits of unconventional steps are reducing inflation-adjusted interest rates, making U.S. exporters more competitive by lowering the value of the dollar in foreign exchange markets, and giving private investors greater incentive to move money into corporate bonds or the stock market as government bonds become scarce.
Fed officials are also looking for unintended consequences of new measures. For example, would the Fed crowd out private bond buyers and thus damage the ability of financial markets to function in the longer term? How would buyers of Treasury bonds, whether pension funds or the Chinese government, react?
And even if Bernanke and his colleagues decide to pull the trigger, the question remains how to do it. There is the "big bang" approach, in which the Fed announces in one fell swoop plans to buy, say, $1 trillion in bonds over the coming months. There is also the "dribs and drabs" approach in which the central bank announces smaller purchases at every policy meeting, calibrating them with the most recent economic data.
The weight of the decision adds additional importance to economic data coming between now and Nov. 2.
"If we're not making any progress on reducing unemployment over the year ahead, I would expect the arguments in favor of action to carry the day," said Peter Hooper, chief economist for Deutsche Bank. "If that is the situation, I would expect them to use all the ammunition they have available."