WASHINGTON (Reuters) - Europe's escalating debt crisis is emerging as a top concern for Federal Reserve officials and could nudge them closer to more bond buying or extending "Operation Twist," the U.S. central bank's most recent program to lower long-term borrowing costs.
The turmoil in the euro zone has risen to near fever pitch with investors withdrawing funds from Spanish banks and political gridlock in Greece raising the prospect it could abandon the common currency.
As the crisis has intensified, worries have grown that turbulence in Europe could derail the U.S. economic recovery for a second straight year.
"What's going on in Europe is obviously a clear and the most significant downside near-term risk to the domestic economy," said Jeremy Lawson, an economist at BNP Paribas in New York.
Despite a sluggish U.S. recovery and still high unemployment, the Fed had looked to be on course to keep monetary policy on hold for a prolonged period, and its next policy meeting, on June 19-20, was expected to hold little drama.
Officials were counting on the Fed's already super-easy monetary policy stance to lift growth enough to gradually reduce unemployment, and they widely believed that long-term lending by the European Central Bank had calmed the euro zone storm.
That changed on May 6 when Greek voters enraged by economic hardship turned against mainstream parties in a national election, throwing the country into political disarray and putting its future in the euro zone at risk.
As European officials grappled to find solutions, U.S. stock markets have tumbled and yields on U.S. Treasury debt have reached record lows as investors flocked to safety.
The outcome of fresh Greek elections on June 17, just two days before Fed officials gather, could go a long way in determining whether the U.S. central bank can remain on the sidelines.
The base case is for no change in policy, but officials are not ruling out the possibility of offering the economy some form of monetary support if events in Europe break badly. Extending Operation Twist, which is due to expire at the end of June, would be the likely first port of call.
"The crisis in Europe has put the Fed back in play," said Millan Mulraine, a strategist for TD Securities in New York.
The Fed cut benchmark borrowing costs to near zero three and a half years ago and has bought $2.3 trillion in bonds to spur growth. In September, it launched "Operation Twist" to lengthen the average maturity of its portfolio in a further effort to encourage spending and investment.
After the Fed's last meeting in April, Chairman Ben Bernanke left open the possibility the central bank would act to stimulate the economy further if progress reducing unemployment petered out.
Unusually warm weather helped spur economic activity and lift job growth during the winter, and employment gains slowed sharply over the past two months. However, a report on private sector hiring in May on Thursday suggested some of the recent weakness could be more than weather-related.
A government report on May employment due out on Friday could provide further clues on the trajectory of the U.S. recovery.
Analysts expect the economy created about 150,000 jobs in May, at the bottom end of what Bernanke has said would be needed to achieve the Fed's projection of an unemployment rate of between 7.8 percent and 8 percent by the end of the year, but not weak enough to spur the Fed into action. The jobless rate stood at 8.1 percent in April.
With the U.S. economy muddling along, the Fed's worry wall is dominated by the specter of a messy Greek exit from the euro.
The president of the New York Federal Reserve Bank, William Dudley, said on Wednesday that U.S. bank exposure to troubled countries on the periphery of the euro zone is "very modest" and that U.S. banks are in a much better position than in the past to withstand contagion from Europe.
Still, he warned, the United States would not be immune if Europe's situation were to worsen.
Officials worry that stock markets, already under pressure from European events, could plunge as investors dumped risky assets, weighing on the value of assets on bank balance sheets.
The Fed's initial response would likely be in the form of providing liquidity facilities to financial institutions similar to the ones it deployed during the 2007-2009 financial crisis. These facilities provided access to funds for banks, money market mutual funds, and business, consumer and student lenders to prevent a financial panic and a credit freeze.
However, the possibility that the upheaval could throw the modest U.S. economic recovery into a tailspin would open up the prospect of the Fed extending or reviving the Twist portfolio rebalancing effort, or perhaps even launching a fresh round of bond purchases - known as quantitative easing.
"If we do have a major disruption, that would auger for quantitative easing to forestall any deflation risk," Mulraine said.
Officials at the central bank, however, think they could get a meaningful amount of stimulus by extending Operation Twist, which has one advantage over outright bond buying: it avoids raising anxiety that an expanding Fed balance will provoke a damaging bout of inflation.
"I don't think expansion of the balance sheet, in any way, compromises the Fed's ability to keep inflation in check over the longer term," Dudley said last week.
"But it doesn't matter just what I think," he added. "If people in the market think that expansion of the balance sheet could cause future inflation, we have to take those expectations into consideration as a potential cost of monetary policy."
Analysts question whether the Fed would accomplish much with an extension of Twist. If the economy were to take a big hit, it could be helpful to drive inflation expectations higher with an outright expansion of the balance sheet, Mulraine said.
When the Fed launched Operation Twist last year, it committed to buying $400 billion of Treasury securities with maturities of six to 30 years and to selling an equal amount of Treasuries with remaining maturities of three years or less.
Some analysts believe the central bank is running short of securities to sell, but the Fed could shift to selling securities with maturities of longer than three years and still lengthen the average maturity of its portfolio.
With additional reporting by Pedro Nicolaci Da Costa in Washington and Jonathan Spicer in New York; Editing by Leslie Adler