Fed to give economy therapy, not shock treatment

The Federal Reserve, facing rising global financial strains and recession fears, is poised to increase downward pressure on longer-term interest rates next week in a bid to accelerate a sputtering U.S. recovery.

With one eye on escalating debt turmoil in Europe and another on a stubbornly high 9.1 percent U.S. unemployment rate, the Fed, whose policy panel meets next Tuesday and Wednesday, looks set to begin shifting the composition of its balance sheet to weight it more heavily with longer-term securities.

Having taken short-term interest rates to near zero and bloated its balance sheet with bond purchases that topped $2 trillion, analysts say the U.S. central bank is looking for smaller-bore ways to increase its support, such as shifting its holdings away from shorter-term debt.

That sends a signal the Fed is still active in supporting growth, said Michelle Meyer, an economist for Bank of America Merrill Lynch.

A torrent of weak U.S. economic data has dashed hopes for a robust second half of the year after a disappointingly weak start, casting a shadow over the meeting.

U.S. growth advanced by less than a 1 percent annual rate in the first half of 2011, and Fed officials have acknowledged a need to downgrade their forecasts.

As prospects for a robust recovery crumbled over the summer, Fed Chairman Ben Bernanke announced in late August that policymakers would expand their September meeting from one day to two. Officials will use the time to haggle over what, if any, action to take to prop up the recovery.

DETERIORATING OUTLOOK

In the United States, a debt downgrade after a bruising political battle over raising the nation's borrowing limit has chilled business and consumer confidence. Employers added no jobs on net in August, a blow to hopes for an upswing in hiring.

At the same time, Europe's debt crisis has intensified, pressuring European banks and scaring investors away from risk around the world. U.S. President Barack Obama on Tuesday pressed the euro zone's major countries to take firmer control of the situation, and Treasury Secretary Timothy Geithner announced plans to attend a euro zone finance ministers' meeting in Wroclaw, Poland on Friday.

Other central banks have had to shift their policy focus in response to the dimming outlook. The European Central Bank took no action last week after a series of rate hikes, while the central banks of Canada, South Korea and Indonesia, among others, opted against removing any policy stimulus.

NO, NO, NO

With storm clouds looming, Fed sentiment looks to have coalesced around some form of reshaping the Fed's $2.8 trillion balance sheet to hold more longer-term securities.

Officials hope the move will push down longer-term interest rates, helping encourage home refinancing and business spending. By lowering long-term yields on U.S. debt, the Fed may also push investors to seek higher returns by shifting to stocks or corporate bonds.

Policymakers are likely to discuss some more extreme alternatives -- such as targeting desirable levels for employment or growth, or adopting a policy that would let them overshoot their inflation target -- but those options would likely be reserved in case the economic situation turns even more dire.

However, Fed officials are sharply divided over the need for more action. Any easing, including the smaller step of reweighing the portfolio, is likely to draw three dissents, as did the Fed's August 9 decision to say it expected to hold interest rates ultra-low at least until the middle of 2013.

While Bernanke would probably like to show the greatest possible Fed unity for any action, analysts do not see the prospect of dissents as an impediment to action.

TWIST OF FATE

The move to buy longer-dated government debt has a history: Operation Twist, which ran from 1960 to 1965. That program was an effort to both tackle a recession and shrink a lingering trade deficit but was not an effort to expand monetary policy.

Fed officials will have to decide how bold they will be with Twist II. A modest approach would be for the Fed to simply replace maturing securities with longer-term ones. An alternative approach would have the Fed actively selling short-term securities to buy longer-dated debt.

Because the roll-off of assets from the Fed's balance sheet is variable and depends on mortgage markets, some analysts think the Fed will opt for sales and purchases to provide regularity and predictability.

They would want to announce a specific schedule, said Alan Levenson, chief economist for T. Rowe Price.

The more dramatic step of buying more bonds outright, while likely to be criticized for risking inflation, cannot be ruled out entirely either.

You wouldn't want to do that until you're so desperate you need to do something big, said Eric Green of TD Securities. A full-blown debt default crisis in Europe might be just such a catalyst, he said.

(Editing by James Dalgleish)