Fed officials still expect the U.S. economy to keep growing. But an updated forecast to be released Wednesday afternoon with the minutes of the Fed's late-June policy meeting is likely to show that officials have trimmed their second-half forecasts—as have many private forecasters.
One topic under debate is the possibility that today's already-low inflation may turn into a debilitating bout of deflation, a broad drop in prices across the economy.
Fed officials disagree on the risk of deflation. A few see it as a threat; others call it very unlikely, Fed officials said in recent interviews.
For now, the Fed—and particularly its most-powerful member, Chairman Ben Bernanke, who has ultimate say—appears to be very much in wait-and-see mode. But differences among his colleagues are growing more evident. One problem: Having already cut interest rates to near zero, most of the Fed's options for spurring growth aren't very appealing.
Some policy makers, including Fed governor Kevin Warsh and Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, Va., are reluctant to revive Fed purchases of U.S. government bonds or mortgage-backed securities, the most forceful action the bank could take if it decides the economy needs more help.
Fed staff estimate that the purchase of $1.25 trillion in bonds in 2009 and early 2010 pushed down long-term interest rates by roughly half a percentage point.
But somes skeptics inside the Fed don't believe the impact was that large and think a new round of purchases might have even less impact because markets are now on a more solid footing. Renewing the purchases would also leave the Fed with a bigger portfolio to shrink, when that time comes, and could backfire if it pushes expectations for future inflation sharply higher.
"We're a long way away from needing to think about starting up asset purchases," Mr. Lacker said in an interview. "The recovery will take time. We just have to be patient and manage it carefully. I don't think this is a time to shift gears again."
Other policy makers—among them Boston Fed President Eric Rosengren, New York Fed President Bill Dudley and, to a lesser extent, Atlanta Fed President Dennis Lockhart—see reviving the purchases as an option that needs to be kept alive, particularly if deflation becomes reality.
"Given the amount of substantial excess capacity that we have in the economy, there is some risk of further disinflation," Mr. Rosengren said in an interview late last week. "The risk of deflation has gone up and is more of a risk than I would like to see at this point."
Inflation, excluding the volatile food and energy sectors, is running around 1%, below the Fed's informal objective of 1.5% to 2%.
The Fed's June 22nd and 23rd meeting marked a pivot point for the central bank. In the first four months of the year, officials mostly discussed how best to unwind the extraordinary support the Fed provided the economy. But in June they began considering what they might do if the economic outlook worsens.
Several developments give Fed officials pause, including Europe's government debt crisis and deepening budget strains on U.S. state and local governments. Financial conditions have tightened since the beginning of the year, though recent stock-market gains are likely to hearten Fed officials as they watch the recovery unfold.
"This is a time to be patient with policy and to see how the economy evolves," Mr. Lockhart said in a recent interview. "This little halting period that we're in now simply brings home the point that economies can go in two directions and we should be considering what we would do under various scenarios."
Private forecasters believe the Fed should sit tight, according to a new Wall Street Journal survey. Only eight of 52 analysts said the Fed should do more now to spur growth.
The debate about whether the Fed should do more, and if so how, is likely to be in the spotlight for the next few days.
On Thursday, a Senate committee will question President Barack Obama's nominees for the Fed board: Janet Yellen, president of the San Francisco Fed; Peter Diamond, a Massachusetts Institute of Technology economist; and Sarah Bloom Raskin, Maryland's bank regulator. Next week, Mr. Bernanke delivers the Fed's semi-annual update to Congress.
In public comments, Mr. Bernanke has played down the risk of a double-dip recession. But he has been keeping his options open.
The Fed is better equipped to solve some economic problems than others. As Mr. Bernanke noted in a now-famous 2002 speech, the Fed has the power to fight deflation—or falling wages and prices—by printing money. But the bank's tools aren't perfectly suited to reducing unemployment, which is influenced by a range of factors including fiscal policy, regulation and global demand.
Besides reviving its bond purchases, the Fed could take less aggressive action. Officials see drawbacks in these steps, too. The Fed currently isn't reinvesting the cash it receives when mortgage-backed securities it has purchased reach maturity or the underlying loans are paid off. It could use that cash to buy new mortgage-backed securities, a signal of its intention to support growth. With mortgage rates already very low, it isn't likely this would have a big impact.
The Fed has promised to keep short-term rates low for an "extended period," and could strengthen that commitment in order to encourage investors to borrow and take more risks.
But several officials are uncomfortable with the language as it is, including Kansas City Fed President Thomas Hoenig, an inflation hawk who has formally voted to remove it.
Moreover, it's not clear the Fed could say much beyond what markets already anticipate. Financial markets and forecasters now expect the Fed to keep its key short-term interest rate near zero well into 2011.
The Fed also could push short-term interest rates lower. The federal funds rate—a Fed-influenced rate at which banks lend to each other over night—is a bit below 0.2%.
By eliminating the 0.25% interest that the Fed pays banks to leave money on deposit with the central bank, the Fed could push the fed funds rate all of the way to zero. That, however, could disrupt the money market industry by eliminating revenues on funds the industry manages, which gives some Fed officials pause.