Fed officials say not running out of policy tools

By Ros Krasny

DEARBORN, Michigan (Reuters) - The year-long U.S. recession has taken a turn for the worse recently, two top Federal Reserve policy-makers said on Thursday, raising expectations for aggressive policy action by the central bank as soon as next week.

Separately, Federal Reserve Chairman Ben Bernanke urged more aggressive steps to halt home foreclosures, one of the most visible outcomes of the severe U.S. downturn.

Chicago Federal Reserve Bank President Charles Evans said that the economy is "contracting markedly" as consumer spending sinks and the jobless rate rises, and that a recovery might not be on tap until 2010.

"The outlook has clearly deteriorated" in the past six weeks, Evans told reporters after a speech to the Michigan Bankers Association in Dearborn.

Evans' comments were echoed by Atlanta Fed President Dennis Lockhart, who spoke at an energy conference in New Orleans and termed the near-term outlook "not encouraging."

"Employment is expected to weaken further," Lockhart said. House prices likely will continue to fall, with a further erosion of household wealth, while consumer spending will likely decline at least for the next few months.

Evans and Lockhart will be voters on the central bank's policy-setting Federal Open Market Committee in 2009.

Both policy-makers said the central bank has the tools to tackle current weakness and additional shocks, even as benchmark interest rates -- the traditional means of manipulating monetary policy -- are close to zero.

Evans said the Fed needed to use "all weapons in its arsenal" based a downward lurch in the economy even since the late-October FOMC meeting.

"The incoming data, particularly on consumer spending and labor market conditions, have been weaker than I expected," Evans said. "We need to make policies appropriately accommodative. We will be thinking very broadly."

The FOMC has already dropped its benchmark lending rate to 1 percent from 5.25 percent since September 2007 in an attempt to stabilize financial markets and stem economic weakness.

Participants in the financial markets anticipate at least a half percentage point cut in the Fed's benchmark lending rate at the Dec 15-16 policy meeting, to 0.5 percent, with a strong chance the rate will be cut to 0.25 percent.

A chorus of Fed watchers expect the FOMC to lower fed funds to zero by January, and to expand quantitative measures to pump more liquidity into markets, echoing efforts by Japan's central bank to revive that country's economy in the 1990s.

"The Fed has a number of options to help ease the economy through this difficult transition," Lockhart said.

The U.S. central bank could continue to boost market liquidity even though interest rates cannot fall below zero, he said. "There are many other mechanisms that the (FOMC) can use to provide liquidity."