Fed debates winding road to more easing

Even with U.S. interest rates already near zero, Federal Reserve policymakers will still spend much of a meeting on Tuesday discussing ways to offer more rather than less monetary stimulus to the economy.

The problem is that despite the most aggressive rate-cutting campaign in the central bank's history and Fed purchases of nearly $1.5 trillion in mortgage and Treasury bonds, U.S. growth prospects still look shaky.

In particular, the latest employment numbers confirmed that the outlook is souring as the year progresses, raising the possibility that things might get worse rather than better and potentially raising the risk of another recession.

For this reason, investors around the world will scour the U.S. central bank's policy statement for clues, however cryptic, that the Fed is ready to add fresh impetus to its unorthodox approach to lowering borrowing costs.

Any hints of further policy easing could have big implications for global financial markets, potentially providing a catalyst for renewed selling of the U.S. dollar and at least a temporary boost to stock prices around the world.

Fed Chairman Ben Bernanke has already outlined steps the central bank is considering as possible ways to create even greater incentives to lend and borrow.

Friday's U.S. July employment data, which showed the private sector added a modest 71,000 jobs last month and sharp downward revisions for June, only reinforced the chances that the central bank may do something sooner rather than later.

The Fed would likely reach for the lower-hanging fruit at first by reinvesting proceeds of maturing mortgage bonds back into new securities or reducing the modest premium it pays banks for keeping their excess reserves at the central bank.

I don't think they really want to take a strong step at this point, said Dean Croushore, former Fed economist and professor of economics at the University of Richmond. They kind of want to hint at it and wait for the data. But there will be a pretty strong discussion at this meeting.

DEPLETED ARSENAL

But if the recovery does stall and the unemployment rate edges higher, Bernanke and his colleagues will probably not be shy about beefing up their purchases of Treasury bonds.

Still, success is not guaranteed.

The Fed will probably talk more seriously about more quantitative easing and what they can do, but the truth is, there isn't really much, said Steve Blitz, senior economist at Majestic Research in New York. It's not an interest rate problem, it's demand for product.

The Fed is not the only central bank in this predicament. The Bank of Japan finds itself in similar straits, even if it is far more accustomed to confronting economic stagnation and deflation than the Fed.

The BOJ, which also meets on August 10, is expected to keep its policy rate steady at 0.1 percent. But it may be forced into easing policy further if the yen, which has risen near a record high against the dollar, continues its upward march. Expectations for further Fed easing have been a key driver of the yen's rally.

Unlike the United States, Japan's jobless rate is only 5.3 percent, historically high but just over half its American counterpart.

The U.S. employment problem is proving a political hot-potato for Democrats, who are fighting hard to retain majorities in the House of Representatives and Senate in mid-term elections in November.

The House this week is taking the rare step of interrupting its summer recess to return to the Capitol so lawmakers can pass an election-year jobs bill intended to help states cope with historic budget shortfalls.

There are plenty of reasons to worry about the job market. Nearly half of unemployed Americans have been without a job for six months or more.

The economy will not recover overnight, said John Challenger, labor market expert and CEO of outplacement firm Challenger, Gray & Christmas. It took 21 months before we saw consistent job gains following the 2001 recession, and that was considered a mild recession.

(Reporting by Pedro Nicolaci da Costa; Editing by Dan Grebler)