By Pedro Nicolaci da Costa
WASHINGTON (Reuters) - The Federal Reserve on Tuesday began a two-day meeting against the backdrop of a weakening U.S. economy that will likely force policymakers to plan for the possibility that things may get worse.
The central bank's quarterly forecasts, which will be released after the meeting, are likely to be revised down to reflect the recent weakness in the recovery, though officials should reiterate their expectation for a second-half rebound.
With underlying inflation moving higher and officials still smarting from the barrage of criticism that followed their latest round of stimulus, the Fed remains leery of taking any additional steps to support the recovery.
However, recent signs the economy is sputtering, evident in manufacturing activity and employment, will put any debate about withdrawing stimulus on the backburner.
"They'll have to acknowledge that the recovery has decelerated, but want to avoid fanning the fires of QE3 expectations," said Ward McCarthy, chief financial economist at Jefferies & Co, referring to a potential third round of bond buying, or quantitative easing.
For now, the Fed looks set to repeat its commitment to keeping interest rates low for an extended period, while also reiterating its intention to continue reinvesting proceeds from maturing bonds it holds back into the Treasury market.
It will also have to describe the inflation outlook with some nuance, since energy costs have come down rapidly even as "core" inflation readings that exclude food and energy have moved higher. The Fed's post-meeting statement is due at around 12:30 p.m. EDT on Wednesday.
Officials have made clear the hurdle to any further easing is high, and analysts are increasingly talking about policy fatigue. But there are options the Fed could pull from its unconventional policy playbook if needed.
A speech by Fed Chairman Ben Bernanke in August provides the clearest roadmap for steps the central bank might consider if the economy stumbles badly. Such steps include not only additional bond purchases but also a potential bolstering of the extended period language -- some economists say even possibly a vow to keep the balance sheet steady at a record $2.8 trillion.
"The Fed is not out of bullets," said David Greenlaw, chief U.S. economist at Morgan Stanley.
LISTENING TO THE CHAIRMAN
Analysts will pay close attention to Bernanke's second-ever news briefing at the conclusion of the meeting for clues into how his thinking on the matter of alternative policy options has evolved.
Bernanke is likely to face tough questions about Greece's debt problems and their implications for Europe and the global financial system. But he probably will not offer many specifics, saying simply the Fed is monitoring the situation and does not expect a major impact on the United States.
The economy grew 1.8 percent in the first quarter on an annualized basis, and the second quarter's performance is not likely to prove much better. On the employment front, the country added just 54,000 net new jobs in May, while the unemployment rate climbed to 9.1 percent.
That is hardly the sort of outcome the central bank expected after launching a $600 billion bond-buying stimulus back in November. The program was widely criticized for raising the risk of future inflation without being very effective.
While inflation pressures remain under control, the bang-for-the-buck from the Fed's monetary ease has been disappointing in the eyes of some analysts.
At the same time, high commodity and energy costs that some blame on the Fed's ultra-easy policy stance have come back to haunt consumers, retarding the recovery.
For now, the Fed will be looking to buy some time to see how the economy performs over coming months. Its April forecasts saw the economy expanding between 3.1 percent and 3.3 percent this year. The extent to which policymakers revise these numbers will offer hints into how dire they believe prospects have become.
"They'll do what they have to do," said McCarthy from Jefferies. "If, some months down the road, it looked like the economy was headed into a nose dive they'd probably pull a QE3 off the shelf."
(Editing by Andrea Ricci)