Slowing economy may force Fed to take action

Win Mcnamee / Getty Images

Fed Chairman Ben Bernanke testifies before the Joint Economic Committee on Capitol Hill earlier this month.

By Roland Jones

With the dark cloud of Europe?s ongoing financial crisis still hanging over the world financial system, the Federal Reserve opened a two-day meeting?Tuesday?with speculation swirling that policymakers could announce more stimulus to boost the U.S. economy.

A crucial Greek election over the weekend eased fears of an imminent financial disaster in the eurozone by handing?victory to New Democracy, a center-right party that supports Greece staying in the currency union. That means, for now at least, investors can stop worrying about the market chaos that would follow a Greek decision to?leave the eurozone.

Now the focus shifts to the Fed and how it might play its next hand.

Recent reports, including two straight months of weak job growth, suggest?economic growth is slowing again after a tepid recovery. That sets the stage for?Fed Chairman Ben Bernanke to ask central bankers to approve more stimulus, although the options are limited. In?testimony this month Bernanke said the Fed stands ready to act if needed.

Opinions are divided over what the Fed will do.

Some economists expect policymakers to extend ?Operation Twist,? a program launched last fall that adjusts the composition of the government bonds held by the Fed by swapping short-term assets for longer-term assets. The idea is to push down long-term interest rates, making it easier for businesses and consumers to get credit. The program is due to end?June 30, although the?Fed could opt to extend it beyond that date.

Others are hoping for something stronger, such as another massive bond-buying program known as ?quantitative easing,? or QE, in which the Fed essentially?prints?money to buy long-term mortgage or Treasury bonds.

That would be?controversial?because past efforts have had a?questionable success rate, and it brings with it the risk of inflation down the road because it increases the money supply. Also, economists say the Fed is likely to want to keep something in its arsenal in case the?economic outlook worsens further?over the summer.

An extension of ?Operation Twist? is?the most likely first step, according to Former Richmond Fed President Al Broaddus.

?I think if there?s a significant risk, and action is needed, they may need to do something this week,? Broaddus told CNBC. ?My guess is it will be some kind of modification of Operation Twist.?

He said the?focus of the meeting would be?domestic U.S. conditions with some discussion of the eurozone crisis.

Barclays Capital strategists Alan James and Edmund Shing are also expecting an extension to the Fed?s Operation Twist, pointing to weakness in manufacturing output and in consumer sentiment.

?The soft patch in U.S. economic data keeps getting larger,? they wrote in a research note Monday.

One of the only other options open to the Fed is to adjust interest rates, which are already at record-low levels near zero. In January the Fed said it plans to hold down rates until late 2014 to sustain the economic recovery. The Fed would now have to signal to the market that it plans to hold rates down even further into the future.

The worsening debt crisis in Europe and fears over whether?Congress will hold off on tax increases and government spending cuts that are supposed to start in 2013 -- also known as the ?fiscal cliff? -- are weighing on consumer and business confidence.

Signs that Europe?s woes, which investors fear will have negative repercussions on the U.S. economy, are far from over were seen Monday when Spanish borrowing costs soared, with 10-year bond yields hitting 7.30 percent -- the highest in the eurozone?s history and above the rate that has forced other struggling euro-area nations to seek an international bailout.

Still, the troubles in Europe shouldn?t factor too heavily in the Fed?s plans this week, said Dino Kos, a former New York Fed executive vice president. Weakness in Europe should already be factored into the Fed?s forecast, he told CNBC.

?It shouldn?t really affect their thinking, although the situation has obviously gotten worse,? he said. ?The way it should impact their thinking is does the European slowdown affect U.S. growth, and does the growth then come down to such a degree that they need to counter it??

Kos said the best position for the Fed this week would be to hold fire, given the potential negative consequences of the fiscal cliff.

?Do you want the Federal Reserve to have something in reserve?? he said, noting that there are many uncertainties surrounding the fiscal cliff, given its timing, and the uncertainties about what the political situation will be at the end of the year.

?I would say they should wait,? he said.

Reuters contributed to this report.

Dino Kos, former NY Federal Reserve Bank executive vice president and Alfred Broaddus, former Richmond Federal Reserve president, discuss the outcome of Sunday's election in Greece; the impact on U.S. markets and the economy; and whether the Fed will i...

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