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Will Fed take steps to lower borrowing costs?

Federal Reserve officials are increasingly worried about the U.S. economy's health, making it likely the U.S. central bank will soon take further steps to try to lower borrowing costs.
/ Source: Reuters

Federal Reserve officials are increasingly worried about the U.S. economy's health, making it likely the U.S. central bank will soon take further steps to try to lower borrowing costs.

The Fed's policy-setting panel meets next week, and while that may be too early for any concrete steps, it might offer a good place to plant the first seeds of a directional shift -- away from any exit strategy and towards further easing.

The Fed, which has already said it is weighing its options, may choose to signal this change by taking small steps at first. It could do that by starting to reinvest the proceeds from mortgage-backed bonds in its portfolio as they mature, or by lowering the interest it pays on bank reserves.

Officials are well aware that such moves would have only a marginal effect on borrowing conditions. Their intent would simply be to lay the groundwork for further moves if the economy remains moribund. Those easing steps would likely center on additional purchases of U.S. Treasury bonds.

To combat the financial crisis and deep recession, the Fed bought more than $1.1 trillion in mortgage securities and $300 billion in longer-term Treasuries.

The central bank already has an overwhelming presence in the mortgage market, so buying more Treasuries has become the most likely avenue for any further substantial easing that might take place.

Jobs report may hold key
Fed Chairman Ben Bernanke and St. Louis Federal Reserve Bank President James Bullard were only the latest in a string of top officials to flag their uneasiness about the outlook.

Bullard was most explicit, citing a growing danger of deflation during a conference call with reporters last week and saying the Fed should be prepared to resume asset purchases if conditions worsen.

Bernanke was less specific in a speech Monday. But while he offered few new clues on the immediate outlook for policy and said he expected the economy to continue growing, he did warn the recovery was not yet firing on all cylinders.

"We need to make sure that monetary policy continues to provide the support the economy needs until we begin to see growth, sustained growth and particularly growth in jobs," the Fed chief said.

Many economists believe the United States will face a prolonged period of sub-par growth, even if it avoids a double-dip recession, as the effects of a heavy cocktail of government spending and steep interest rate cuts fade.

A struggling labor market, marked by employers' heightened reluctance to hire, is the most painful reflection of this fragility. Data on Friday that is expected to show a second straight month of net declines in employment could seal the deal for Fed policymakers, particularly if it is unequivocally weak.

Economists are looking for a loss of 65,000 jobs as temporary workers hired by the government to conduct the decennial census are let go. The private sector is expected to have added only 90,000 new jobs -- not enough to keep unemployment from rising.

The latest tally of U.S. gross domestic product, the broadest measure of economic activity, offered plenty of reason for concern. The headline number itself showed a sharp retrenchment in the pace of growth, to a 2.4 percent annual rate in the second quarter from 3.7 percent in the first.

But the composition of growth was also troublesome, with the pace of growth in consumer spending moderating and inventories still on the rise. Given the lack of sustained private demand, firmer inventories could mean a further slowdown in production in the months ahead.

Omens of such an outcome were already evident in the Institute for Supply Management's manufacturing survey for July. It showed the sector's expansion slowing to its weakest level in a year and a worrisome drop in new orders.

"If the stimulus package was a box of doughnuts dumped on the economy, we only have one or two doughnuts left in the box," said Jack Ablin, chief investment officer at Harris Private Bank in Chicago.

Unfortunately for the Fed, which gathers on Tuesday, its own stash of doughnuts is looking rather depleted as well.