Q+A: What is Fed weighing as it mulls more easing?

WASHINGTON Tue Aug 9, 2011 9:43am EDT

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WASHINGTON (Reuters) - The Federal Reserve is considering renewed efforts to boost growth should the weak U.S. economic recovery and high unemployment take a turn for the worse.

Even though employers added a surprisingly hefty 117,000 jobs in July and the jobless rate slipped a tenth of a percentage point, no one argues the job market is robust. Officials will remain vigilant for signs subpar growth is entrenched or is at risk of petering out altogether.

The possibility that financial market strains from the ongoing debt crisis in Europe and jitters following Standard & Poor's downgrade of U.S. debt boost chances the Fed may consider actions to buttress recovery.

The Fed has already mounted one of the most aggressive central bank easy money campaigns in history: it cut interest rates to near zero in December 2008 and has since bought $2.3 trillion in assets to provide an additional prod to economic activity.

Yet officials maintain the Fed still has arrows in its quiver -- should conditions warrant firing them.

WHAT COULD THE FED DO?

* It could return what appears to have been its most potent conventional tool, another round of large-scale asset purchases.

* It could make a smaller move, such as deliberately restocking its balance sheet to emphasize longer maturities, pushing down longer-term interest rates.

* Cement commitments to low rates and easy money in ways that might free up buying, building and hiring. One such initiative might be to bolster its promise to maintain rates low for an extended period; a second might be to promise to keep its much-expanded balance sheet large for an extended period.

Most analysts believe a communications measure or rebalancing of the Fed's portfolio is the most likely first step and that more bond buying would only occur if conditions worsened significantly.

* Setting explicit targets for inflation or price levels. A firm inflation target would strengthen confidence that the Fed won't let inflation get out of hand; a price level target would give the Fed more leeway to spur growth while keeping inflation in check.

* The Fed could lower the interest rate it pays banks on excess reserves, forcing banks to lend the money to obtain higher rates of return.

WHAT PREVENTS THE FED FROM ACTING?

* Inflation worries: after the Fed's $600 billion second round of quantitative easing, or QE2 as it became known, commodity and energy prices soared worldwide. The Fed was blamed for fueling inflation although Chairman Ben Bernanke and other economists argued rising demand around the world was the principal cause of rising prices.

Even so, U.S. inflation is now near the Fed's preferred level of 2 percent or a bit below, depending on the gauge. When the Fed launched QE2, inflation was near record lows.

Bernanke has said that higher U.S. inflation is one restraint on Fed willingness to ease policy.

* Political pressures: the Fed was savaged at home as well as abroad for QE2. U.S. lawmakers took the Fed to task for risking inflation and proposed narrowing its mandate to focus only on price stability, not on growth.

While the central bank has over the years established a reputation for political independence, the risk of stoking further anti-Fed sentiment on Capitol Hill could give policymakers pause.

* Effectiveness questions: although a study by Fed economists said large-scale asset programs lowered rates on 10-year Treasury bills by between .30 of a percentage point and 1 percentage point, impact is a subject of heated debate.

Detractors point to the continued struggles of the economy -- which grew at less than a 1 percent annualized rate in the first half of the year -- as signs of quantitative easing's limitations. Supporters counter that without the bond buying, things would have been worse.

* Policy fatigue: after Fed purchases of near $1.4 trillion worth of mortgage-related debt and $900 billion of Treasury securities, many wonder whether additional bond buying would have diminished effect.

Furthermore, some Fed officials believe that despite stumbles, the recovery is on track and that the Fed's next step should be tightening, not further easing.

* Difficult exit: critics worry that when the recovery begins to gain traction, the Fed will have difficulty shrinking its balance sheet from its current $2.9 trillion size, let alone a larger one. Failure to reverse easy money policies in time could ignite inflation and plunge the economy into a fresh crisis.

Fed officials say they have the tools in place to tighten monetary policy even with a bloated balance sheet. However the reversal of quantitative easing on such a large scale has never been undertaken before.

WHAT WOULD THE FED HOPE TO ACCOMPLISH WITH MORE STEPS?

* Quick response: although the Fed was criticized for being slow to react initially to the financial meltdown that began in mid-2007, Fed Chair Bernanke's track record reflects a willingness to take bold steps quickly in response to deteriorating conditions.

* Emphasize growth: even a smaller step such as a commitment to maintaining a large balance sheet would signal to markets that the Fed sees weak growth, and not rising inflation, as the main risk to the recovery, but would do so without the potentially controversial step of committing to another sequence of bond buying.

* Encourage risk-taking: moving to longer maturities could push down interest rates for longer-dated securities and push investors to take on riskier assets, such as stocks.

* Lower interest rates: by weighting the Fed's portfolio to longer-dated maturities, buying more bonds, the Fed would be pushing down longer term rates even more, thus encouraging borrowing and hopefully, spending, investing, and hiring.

(Reporting by Mark Felsenthal)

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