Fed to meet amid market havoc

WASHINGTON, Aug 8, 2011 (AFP) - The US Federal Reserve meets Tuesday to review policies amid doubts about what it can do to beat off another turn toward recession and plunging equity markets after the US credit downgrade.

AFP - The US Federal Reserve emblem is seen on August 08, 2011 in Washington DC
AFP - The US Federal Reserve emblem is seen on August 08, 2011 in Washington DC

Meeting the day after the stock markets took their deepest plunge since the crisis of 2008, Fed chairman Ben Bernanke and his interest rate-setting team have face their toughest challenge yet this year shoring up confidence in what they have repeatedly called a "recovery" that looks less and less like one.

Already pressure is building to adopt a new stimulus program after the expiration of the $600 billion "QE2" -- for quantitative easing -- though many doubt that boosting liquidity in the system will help spark more growth.

"We assume that a further easing of monetary policy will be up for serious debate" in the one-day meeting of the Federal Open Market Committee, said Harm Bandholz, chief US economist at UniCredit Bank.

It is the FOMC's first meeting since QE2 expired, and economic data has since shown a stalling economy despite the central bank keeping their ultra-low, near-zero interest rate in place.

In the first half of the year, the FOMC was divided between a majority who believed the economy remained soft, and a minority who believed the economy was gaining steam and faced a burst of easy money-induced inflation.

But growth in the second quarter ultimately proved to be nearly stagnant, and in July Bernanke told a congressional panel that more stimulus could be merited.

"The possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying the need for additional policy support," he said.

He said the Fed could follow in the footsteps of QE2 and increase its purchases of US securities, pushing more liquidity into the economy.

It could also cut a key interest rate it pays to banks on their reserves -- which could help push down commercial lending rates, he said.

But there are doubts that that is the medicine for what the economy faces now.

Since then, the government went to the precipice of defaulting on its debt, before finally raising its own borrowing cap and passing a long-term plan to cut its debt and deficits, on August 2.

But the plan itself failed to impress, and the political battle over it ultimately led Standard & Poor's to deal Washington its first-ever cut to its sovereign credit rating -- the act that put equity markets into a tailspin Monday.

Meanwhile, more, deeper turmoil has broken out in Europe, over Italy's fiscal sustainability, widening the cracks in the eurozone.

And economists are increasingly imagining a possible new contraction in the US economy that a new boost of liquidity would not help.

Economist Bruce Kasman at JPMorgan Chase said they expect the Fed to send a signal that all the money pushed into the economy -- by buying US bonds -- will not be pulled back in the foreseeable future.

"Last year, a similar signal from the Fed effectively lifted risky assets during August and September," he said.

On the other hand, he said the likely response Tuesday will be more muted.

"First, QE2 did not deliver the 'escape velocity' for the expansion and there will be thus less conviction that the Fed can turn the tide this time," he said.

Secondly, he added, the FOMC is more and more divided over the course forward and so is likely to be more cautious over sparking inflation, as well as having "possibly less conviction on the effectiveness of monetary tools."

But there will be pressure to show something -- though Bernanke is not planning to give a post-meeting press conference as he did last time.

"The Fed has to do something... after the 635-point horror show" of the Dow Jones Industrial Average Monday, said Ian Shepherdson of High Frequency Economics.

"But what? We do not expect the Fed to announce QE3," he continued.

"US monetary policy cannot fix the core problem of the lack of growth at home and in the benighted economies of the eurozone."

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