No end in sight for Fed stimulus as inflation sags

By Pedro Nicolaci da Costa

WASHINGTON (Reuters) - The Federal Reserve's debate over U.S. monetary policy could begin to shift away from the prospect of reducing stimulus toward a discussion about doing more, given the signs of economic weakness and slowing inflation.

But policymakers are not there yet.

At a two-day meeting that wraps up on Wednesday, the Fed is widely expected to maintain its monthly purchases of $85 billion in bonds to support an economic recovery that is nearly four years old but still too weak for the job market to truly heal.

With the central bank's favored inflation gauge slipping and employment growth faltering, Fed officials could again find themselves in the uncomfortable position of having to shift from talk of curbing stimulus to the possibility of doing more.

Currently, analysts see the Fed buying a total $1 trillion in Treasury and mortgage-backed securities during the ongoing third round of quantitative easing, known as QE3. Until recently, analysts had believed the Fed would start taking the foot off the accelerator in the second half of the year.

Now, things are looking a bit more shaky.

The housing market continues to show signs of strength, with home prices posting their biggest yearly gain since 2006, the year the market began a historic slide that snowballed into a global financial crisis.

However, the industrial sector is not quite as perky. Durable goods orders posted their largest drop in seven months in March, while an index of Midwest manufacturing showed an unexpected contraction in the sector for April.

Economic growth did rebound in the first quarter after a dismal end to 2012, but the 2.5 percent annual rate of expansion fell short of economists' estimates, and economists are already penciling in a weaker second quarter.

At the same time, inflation has steadily been coming down. The Fed's preferred measure of core inflation, which excludes more volatile food and energy costs, rose just 1.1 percent in the year to March. Overall inflation was up just 1 percent, the smallest gain in 3-1/2 years.

The Fed targets inflation of 2 percent.

CHECKING THE TOOLKIT

Despite the economy's softer tone, a wait-and-see attitude seems the most likely approach for now. The Fed is expected to nod to the economy's disappointing performance when it announces its decision at 2 p.m. (1800 GMT), even as it maintains its course.

But if the economy's fortunes do not improve, the U.S. central bank may well look for fresh ways to boost its support to the economy -- increasing the amount of assets it is buying is just one option.

The Fed could announce an intent to hold the bonds it has bought until maturity instead of selling them when the time comes to tighten monetary policy. Fed Chairman Ben Bernanke has already raised this as a possibility.

U.S. central bankers could also set a lower unemployment threshold to signal when the time might be ripe to finally raise overnight interest rates, which they have held near zero since December 2008. Currently, the threshold stands at 6.5 percent, provided inflation does not threaten to breach 2.5 percent.

Research suggests such "forward guidance" about the future path of interest rates can have a strong impact on current borrowing costs, and one Fed official -- Narayana Kocherlakota, president of the Minneapolis Federal Reserve Bank -- has already suggested lowering the threshold to give the economy a boost.

"Forward guidance would be perceived as having lower costs (than bond purchases) by most, I think, and for that reason I think it could be the preferred avenue, especially if more stimulus was projected to be needed for a long period of time," said Roberto Perli, a partner at Cornerstone Macro in Washington and a former Fed economist.

Analysts generally agree that is a debate for the future, if the Fed even gets there at all.

Victor Li, a former regional Fed economist who teaches at Villanova University in Pennsylvania, said employment growth would have to be consistently below the 100,000 jobs per month pace in combination with core inflation of around 1 percent for the Fed to consider a greater easing of monetary policy.

"There is just no evidence that this is going to happen."

Others are less sanguine. Justin Wolfers, an economics professor at the University of Michigan's Gerald Ford School of Public Policy, said the risk that prices will drop persistently, causing further economic damage, cannot be ruled out.

"What's more relevant than the current inflation trend is what this means for forecast inflation," Wolfers said. "And I think even more relevant than the Fed's official point estimate for inflation is the probability that deflation looms as a real threat. Inflation rates lower than 1 percent certainly raise a greater risk of deflation."

(Reporting by Pedro Nicolaci da Costa; Editing by Tim Ahmann and Leslie Adler)

Source: http://news.yahoo.com/no-end-sight-fed-stimulus-inflation-sags-040556054.html

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