September 21, 2010 / 6:00 AM / 9 years ago

Fed lays groundwork for possible further stimulus

WASHINGTON (Reuters) - The Federal Reserve on Tuesday inched closer to fresh steps to bolster a sluggish U.S. recovery, saying it stood ready to provide more support for the economy and expressing stronger concerns about low inflation.

U.S. Federal Reserve Chairman Ben Bernanke arrives to testify before a House Financial Services hearing on the "Monetary Policy and the State of the Economy" on Capitol Hill in Washington, July 22, 2010. REUTERS/Jim Young

The U.S. central bank’s policy-setting panel opened the door wider to pumping hundreds of billions of new dollars into the economy, although it made no policy shift at the end of a one-day meeting, keeping overnight interest rates near zero.

“The committee ... is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate,” it said in a statement.

After its last meeting on August 10, the Federal Open Market Committee had simply said it would “employ its policy tools as necessary.”

“The FOMC now has a very explicit easing bias,” JPMorgan economist Michael Feroli wrote in a note to clients. “The Fed is now admitting that they are not hitting the inflation mandate, clearly not hitting the employment mandate and — with subpar growth forecasted for the near term — not even moving in the right direction.”

The expectation for further easing was captured in a Reuters poll of primary dealers taken just after the decision. It showed 10 of the 16 big banks who responded said further accommodation was likely, with seven predicting an announcement could come as early as the Fed’s next meeting in November.

The Fed underscored its concerns over easing price pressures in its statement by explicitly stating for the first time that core inflation was running below levels at which policymakers are comfortable.

“With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time,” it said.

U.S. Treasury debt prices surged after the statement, with the yield on the two-year note hitting a series of record lows, and the dollar fell sharply as investors speculated about further easing as soon as the Fed’s next meeting on November 2-3.

Gold prices, which have jumped about 17 percent this year on concerns that efforts to prop up the U.S. economy will fuel inflation, set a fresh record high.

On Wall Street, U.S. stock prices ended flat to lower in an erratic session.

“The Federal Reserve has taken another step, albeit a half step, in recognizing the unusually sluggish economic and employment outlook and related need for additional policy measures,” said Mohamed El-Erian, co-chief investment officer at bond fund PIMCO.

EYE ON PRICES

Kansas City Federal Reserve Bank President Thomas Hoenig dissented for a sixth consecutive time, reiterating his view that the central bank could allow its balance sheet to shrink and that a vow — repeated on Tuesday — to keep borrowing costs exceptionally low for an extended period was no longer warranted.

After cutting the overnight federal funds rate to near zero in December 2008, the Fed launched an asset-buying program in a further effort to lower borrowing costs and help the economy.

In the end, it bought $1.7 trillion in longer-term U.S. government debt and mortgage-related bonds. Restarting large-scale purchases of government bonds is the Fed’s most likely next step.

Fed Chairman Ben Bernanke said late last month that the central bank was ready to provide more stimulus if needed, but that officials would only act if the economic outlook deteriorated significantly.

The Fed’s statement made plain that the likely path of inflation would be a key guide as U.S. policymakers ponder their next step.

Core inflation, as measured by the Fed’s preferred gauge, was up 1.4 percent in the 12 months to July. Officials would like to see it land between 1.7 percent and 2 percent.

But the Fed said it expected core inflation eventually to rise to levels consistent with its comfort zone.

By emphasizing the need to act against the risk of deflation — a potentially crippling downward price spiral — Bernanke may be making an appeal to the inflation-focused hawks on the panel. Some have said they would only support further easing if deflation was a risk.

FURTHER CURRENCY PRESSURE

The Fed’s easy money policies and the prospect of further easing have driven up the value of currencies in other countries, including Japan and Brazil, as investors moved out of the dollar in search of higher returns — a move that accelerated on Tuesday.

Japan intervened last week to weaken the yen, which had surged to a 15-year high against the dollar, and emerging markets are seeking ways to control huge capital inflows.

The painful U.S. recession ended in June 2009, but the recovery has lost momentum this year with growth tapering to an anemic 1.6 percent annualized rate in the second quarter.

Other economic data over the summer also proved surprisingly weak, prompting analysts to cut their growth forecasts for the second half of the year. A Reuters poll on September 8 found analysts looking for growth in the third quarter to come in at just a 1.8 percent rate.

While the tone of the data has improved in recent weeks, the economy’s sluggish pace and a deeply troubled job market have kept alive fears of another downturn.

Additional reporting by Emily Kaiser, Glenn Somerville and Emily Flitter; Editing by Dan Grebler, Gary Crosse, Leslie Gevirtz

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