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Expect modest steps by Fed to prop up recovery

(MoneyWatch) With the U.S. economy showing signs of slowing down from an already too slow recovery and with fiscal policy ruled out by gridlock in Congress due to the upcoming presidential election, all eyes are turning to the Federal Reserve this week in hopes it can do something to spark growth.

If the central bank is inclined to do more, it has several options. First, it could extend a Fed program called "Operation Twist." This involves trading short-term for long-term assets in the hope of driving long-term interest rates down, spurring more consumption of durables by households, and more business investment.

Second, the Fed could seek to change inflationary expectations by communicating policy more clearly and assertively. For example, it could say that interest rates will remain low for an even longer period than the current commitment to keep interest low through the end of 2013. When inflation expectations rise, the real interest rate falls (because the real interest rate = nominal interest rate - inflation). 

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This option doesn't require the Fed to do anything but talk and suggest things that aren't quite firm promises. That makes it an attractive approach to those worried about inflation (It would be better if the promise was firm, but the commitment to keep rates low through the end of 2013 is always described as conditional on the economy.)

Third, given its recent worries over access to credit for middle- and lower-income households, the Fed could attempt to make credit easier for those households to obtain. However, many people would view this as encouraging risky debt accumulation, and this could cause the Fed to shy away from polices of this type.

Finally, the Fed could engage in a third round of quantitative easing in the hope of driving interest rates even lower than they already are.

The Fed is likely to want to do more to help the economy given recent negative trends in the data, including falling inflationary expectations, which is always a big worry. Yet enough members of the Fed's monetary policy committee are worried about inflation to block any significant expansion of the Fed's balance sheet, as would happen under QE3.

As a result, I expect the Fed to try to lower interest rates through some other means, particularly those with little or no inflation risk. If the Fed is inclined to act -- and there's a good chance it will remain in "wait and see" mode --  some type of communication intended to change expectations, along with attempts to make it easier for worthy middle- and lower-income households to obtain credit are the most likely outcomes.