Fed on sidelines, waiting for recovery to firm

The Federal Reserve is expected to renew its promise to hold benchmark interest rates exceptionally low for an extended period on Wednesday and may acknowledge a slight slowdown in the pace of U.S. economic recovery.

With its decision on borrowing costs not in doubt, financial markets will focus on any softening of the U.S. central bank's characterization of the solidity of the rebound in a statement expected at about 2:15 p.m.

Policymakers resumed their meeting, which began on Tuesday, at around 9 a.m., a Fed spokesperson said.

Fed leaders have said they see a steady but gradual recovery. However, disappointing jobs and housing market reports, financial turmoil in Europe, and a four-decade low in a key inflation metric could prompt them to qualify their description of growth.

A report on Wednesday that new single-family home sales plunged to the lowest annual rate on record in May, as the boost from a tax credit ended, dealt another setback to hopes for a speedy pickup in growth.

We might see more tentative language on the strength of the recovery in the labor market, consumption, housing and financial conditions, said Goldman Sachs chief U.S. economist Jan Hatzius. Overall, it is debatable whether economic activity continues to 'strengthen,' as the Fed said in its April statement, he added.

Fed Chairman Ben Bernanke told a congressional panel earlier this month he believes the economy has effectively made the shift to private demand after a period of government-provided life support. Still, he cautioned that a significant amount of time would be required to restore the nearly 8-1/2 million jobs that were lost over 2008 and 2009.

The Fed's own anecdotal summary of economic conditions around the country since its last meeting found that while conditions were still improving, the pace of growth was modest.

Some Fed officials have said in recent weeks they see the pickup in growth gaining momentum. Kansas City Federal Reserve Bank President Thomas Hoenig has argued the recovery is strong enough, and the risks of inflation from the Fed's easy money policies are serious enough, that raising rates to 1 percent fairly soon is warranted.

Hoenig has used all three of his votes in 2010 to dissent against maintaining the Fed's low-rates-for-a-long-time promise, arguing rock bottom rates set the stage for another dangerous boom-and-bust cycle. But he has been alone.

Analysts look for another dissent from Hoenig on Wednesday.

Bernanke said he expects the world's largest economy to expand at a 3 percent annualized rate this year and gain steam in 2011.

While most economists still expect the Fed's next move to be a rate hike, although not until next year, recent disappointing data have spurred some analysts to question whether the Fed should begin to consider further easing.

The economy added jobs in May, but the lion's share were public sector positions. In addition, mortgage applications have plummeted since a homebuyer tax credit expired at the end of April and sales of both previously owned and new homes slumped last month.

Financial turmoil in Europe on doubts about euro zone member countries' ability to meet debt obligations has roiled financial markets, pushing up interbank lending rates and sparking fears of a renewed credit crunch.

In the United States, bank lending has continued to contract, as banks tighten lending standards and problem commercial property loans on their books crimp their ability to lend.

Against that backdrop, consumer prices excluding food and energy rose a scant 0.9 percent year on year through May. Officials would like to see year-on-year core inflation somewhere between 1.5 percent and 2 percent.

Excessively low inflation could be a problem, as consumers put off spending in hopes prices will fall more and businesses cut prices to lure them back, setting off a dangerous deflationary spiral.

To counter those possible recovery-spoilers, some analysts think the Fed should consider doing more to stimulate the economy, but lowering rates is no longer an option with benchmark interest rates in a zero to 0.25 percent band.

More asset purchases or other quantitative easing to flood the economy with reserves banks can lend would be the most likely course of action.

The Fed is a long way from tightening monetary policy, BMO Capital Markets Chief Economist Sherry Cooper said. I wouldn't rule out a resumption of quantitative easing in coming quarters, especially if the fiscal authorities begin to tighten and core inflation dips into negative territory.

(Editing by Andrea Ricci)