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Fed expected to downgrade US growth outlook

August 10, 2010

The Federal Reserve's interest rate-setting panel will meet Tuesday, under pressure to bolster a weak economic recovery that many fear is grinding to a halt.

The 10-member body is expected to downgrade its assessment of the health of the world's largest economy, as it keeps interest rates at historic lows.

The Fed's policies have come under the microscope in recent months, as investors asked whether the central bank was overly rosy in its previous assessments, calling its credibility into question.

In June, the Fed said the economic recovery was "proceeding" despite headwinds and would remain "moderate for a time."

That language -- which is eagerly watched by investors -- may now be revised to reflect a dramatic slowdown in the pace of the recovery.

"It will be hard to take the Fed seriously if a more forthright acceptance of the array of softer data is not forthcoming," said Ian Shepherdson of High Frequency Economics.

The scale of the slowdown was laid bare last week, when the Labor Department reported 131,000 jobs were lost in July, far more than expected.

On Monday, researchers at the San Francisco regional Fed ditched the ordinarily couched language of central bankers to warn a double dip recession was possible.

"A recessionary relapse is a significant possibility sometime in the next two years," researchers Travis Berge and Oscar Jorda wrote, adding that "the policies that are adopted today could play a decisive role in shaping the pace of growth."

Fed watchers will be looking for any hint of a change in those polices Tuesday, specifically a return to stimulus spending that marked the depths of the recession.

The bank battled the financial crisis by spending more than one trillion dollars, buying up Treasury bonds, mortgage-backed securities and other financial instruments to lubricate markets.

The Federal Reserve may take a tiny step in that direction by reinvesting cash from maturing bonds rather than shrinking its portfolio.

Analysts say that could mean spending anywhere between 100-300 billion dollars over the next year.

"The FOMC faces a tough meeting tomorrow with the market pricing in either a significant change to the statement or, indeed, renewed moves to stimulate the economy, such as re-investing maturing coupons on bond holdings," said UBS analysts in a note to clients.

But some market-watchers doubt the Fed will take such drastic action without a more explicit threat to the recovery.

"Other than implicitly marking down its near term growth outlook, we expect the tone of the FOMC to not be substantially different than June," said Joseph LaVorgna, chief US economist at Deutsche Bank.

"We do not expect the Fed to symbolically announce that it plans to reinvest maturing mortgage backed securities back into the market.

LaVorgna indicated even a modest shift in policy -- such as altering the interest paid on banks' excess reserves held at the Fed -- could upset fragile markets.

"We do not expect the Fed to cut the interest on reserves either, as that would wreak havoc."

Most analysts expect the Fed to ply a middle course, setting out what it will do if things get worse.

"The committee is likely to define what can be done in terms of monetary policy, if the macroeconomic situation were to worsen in the near future," said Thomas Julien of Natixis.

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