By Mark Felsenthal
WASHINGTON (Reuters) - While it's not time for emergency measures, the patient still needs the drip.
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The U.S. economy is grinding so painfully and haltingly toward recovery that the Federal Reserve looks poised to incrementally strengthen the dosage to keep growth on track.
Expect Fed Chairman Ben Bernanke to use a speech at an annual central bank conference in Jackson Hole, Wyoming, next Friday to acknowledge his disappointment over the pace of growth, even downgrade his outlook, and explain which medicines left in the Fed's cabinet are best suited to fortify the economy.
He looks unlikely to reach for shock treatment.
"With the recovery grinding to a halt in the first half of this year and the economy operating perilously close to a second recession, the Fed will remain on guard against a negative surprise on growth, and will be willing to act accordingly," Millan Mulraine, an economist with TD Securities, wrote in a note to clients.
So, how is Fed to administer further remedies?
With interest rate tools well exploited, Bernanke is most likely to focus on the Fed's balance sheet and opt for tinkering with the size and composition of its portfolio to get the world's largest economy out of its funk.
Interest rates are already near zero, and the central bank's policy-setting Federal Open Market Committee just two weeks ago signaled it is willing to hold borrowing costs at rock bottom levels for two years if necessary. There is little more that can be achieved using the rates tool.
Many of the balance sheet steps are well known, and each carries its own risks and rewards, which Fed staff would research carefully. But chances for a major new bond buying operation announced at Jackson Hole would appear limited currently.
In shaping its thinking, the Fed is likely guided by a sense that the current situation, though rather uncertain, merits a cautious approach and does not arise to the crisis proportions seen in 2008 through 2010 that justified bold and aggressive moves.
The last of these - the $600 billion bond purchase program dubbed QE2 because it was the second installment of quantitative easing - was the Fed's response to historically low inflation that risked tipping the U.S. economy into a vicious cycle of falling prices and falling consumption and investment.
The situation today is different.
Unlike mid-2010, U.S. inflation is now higher, and core inflation, which strips out volatile food and energy prices has accelerated. While higher readings are a concern for some Fed officials, they are not raising widespread alarm at the central bank on the assumption that overall inflation will fall as energy prices recede and that core prices will remain in check.
Looming large as a risk factor is Europe's long running sovereign debt saga, which is pummeling U.S. financial markets and business confidence. So far Europe's woes and the market turmoil have not caused distress on the scale of the 2008/2009 credit crisis, but it is worrisome.
NO BIG GUNS
Against that backdrop, Bernanke appears unlikely to reach for dramatic measures, but the Fed could be primed to gradually boost the dosage for the ailing economy over the coming months.
One initial step might be simply to use verbal communication. It could commit to maintain its balance sheet, which has ballooned to $2.8 trillion from a pre-crisis level of around $900 billion, at this high level for an extended period of time -- even adding a timeframe just as it has for the fed funds rate.
Another measure would be to put downward pressure on medium to long-term interest rates, where mortgages are fixed and corporations borrow, by taking steps to weight the mix of assets in the Fed's balance sheet toward longer-maturity instruments. This can be done either by replacing its maturing securities with longer-term ones, or by actively exchanging shorter maturities with longer ones.
"Last year at Jackson Hole when the Chairman laid the groundwork for QE2, inflation was rapidly decelerating -- the opposite is true at present," Deutsche Bank economist Carl Riccadonna wrote to clients.
"As a result, if the Fed does move toward additional accommodation, it may first try to extend the average maturity of its portfolio rather than further expand its asset holdings."
A bolder step would be to buy more bonds, though conditions do not seem to merit that at this juncture. While Fed officials argue bond buying has held longer term rates lower than they would otherwise have been and moved investors to seek riskier assets than safe-haven Treasury securities, the strategy has drawn sharp criticism domestically and internationally.
As a way to tamp down worries that bond buying would spur inflation, the Fed could consider sterilizing new bond buying by simultaneously draining bank reserves. Doing so would remove risk and duration from credit markets, push down interest rates at the longer end of the yield curve, while keeping abundant reserves in check.
FACING THE CRITICS
U.S. critics charge that fresh measures would court inflation. Detractors abroad say bond buying drives down the dollar, drives up commodity prices and unleashes volatile investment flows into emerging markets. Even some within the Fed object to aggressive easing, and the Fed's August low rate pledge drew an unusual three dissents.
The Fed faces domestic political attacks as well. Republican presidential candidate Rick Perry this week said any further Fed monetary easing would be "almost treacherous, treasonous.
But the Fed has a track record of political independence and its credibility stems from a reputation of being free to act regardless of the political winds. To bow to these critics when the economy needed further support would be unusual.
Bernanke has a chance to make his case on Friday.
(With additional reporting by Pedro Nicolaci da Costa. Editing by Stella Dawson)