Fed begins 2-day meeting, eyes alternative tools

The Federal Reserve Building is pictured during a meeting of Federal Reserve policy-makers in Washington December 16, 2008.

WASHINGTON (Reuters) - The Federal Reserve began a two-day policy meeting on Tuesday at which officials will explore ways to revive the economy now that their traditional interest-rate cutting repertoire has been exhausted.

The Fed, which began meeting at 1:30 p.m., is searching for tools to pull the world's largest economy out of a deepening year-long recession. It will issue a policy statement around 2:15 p.m. on Wednesday.

At its last meeting in mid-December, the U.S. central bank dropped its target for the benchmark overnight federal funds rate to between zero and 0.25 percent, and said rates would likely stay unusually low for some time.

The Fed has flooded markets with dollars, more than doubling the size of its balance sheet to more than $2 trillion, and its statement on Wednesday may shed more light on how it plans to support broken down credit markets.

Economists expect the Fed to hold the target steady this week and repeat its low-rate vow as it searches for unconventional ways to combat the recession and a financial crisis that is hammering economies around the globe.

"We expect the Fed announcement to be long on understanding and short on solutions this time around," said Chris Low, chief economist at FTN Financial. "The only sure thing in the Fed announcement is that there will be surprises."

NEW POLICY APPROACH

In December, the Fed said it was considering buying long-dated U.S. government bonds to push down borrowing costs, and investors will eye the central bank's statement closely for clues on whether it might move forward with that plan.

In addition, it said it stood ready to ramp up its purchases of mortgage-related debt in a program that has already helped drive down mortgage costs.

The central bank could also expand a program that targets consumer and small business lending to cover commercial mortgage-backed securities and a wider array of home mortgage debt, although that might require the Treasury Department to put up some money to cover the risk of losses.

In a speech two weeks ago, Fed Chairman Ben Bernanke said officials were focusing on "credit easing" policies that rely on lending or the purchase of securities to lower private borrowing costs.

"They allow the Federal Reserve to continue to push down interest rates and ease credit conditions in a range of markets, despite the fact that the federal funds rate is close to its zero lower bound," he said.

Banks saddled with huge losses have cut back sharply on lending, choking off credit to an economy already suffering from a big housing crash.

The U.S. economy shed 2.6 million jobs last year, the deepest slump in employment since 1945. In the third quarter, it shrank at a 0.5 percent annual pace and economists expect a report on Friday to show a 5.4 percent fourth quarter contraction, which would be the deepest since 1982.

(Additional reporting by Ros Krasny, Editing by Chizu Nomiyama)