Fed Downgrades Economic Forecast; Dilemma at Hand

The Federal Reserve has downgraded its forecast for economic growth in the second half of the year and into 2011.

In fact, Fed officials believe it could take five to six years before the US economy is fully recovered from the Great Recession of 2008.

The Fed foresees more years of high unemployment, very low interest rates, continued deleveraging, and the persistent threat of deflation.

With the economy showing signs of faltering, Fed officials are considering a range of options to stimulate growth. But the reality is that, in this battle, the Fed may have finally run out of bullets.

After spending the beginning of this year talking about how to exit from its extremely loose monetary policies that injected trillions into the banking system and housing market, the Fed is now wondering what more it can do to increase demand and stimulate growth.

However, there's a disagreement at the Fed Board about exactly what is happening, and what they should do about it. There are those at the Fed who fear inflation, while others worry about deflation.

The ones who worry about deflation are starting to think the Fed should be doing more. But with interest rates already near zero, you have to wonder, what more can they do? Mortgage rates are already near all-time lows.

Last year, the Fed bought $1.7 trillion worth of mortgage bonds and Treasury debt. Perhaps they could try more of that, but how much further can they expand the Fed's balance sheet? Massive infusions of cash into the economy would have the same effect on the Fed's books. And there are disagreements among Fed officials about how effective that would be anyway.

If the Fed were to launch a new asset-purchase program, that may cause global investors to lose faith that the Fed will be able or willing to pull money out of the economy in time to prevent inflation. That would lead the investors to demand higher interest rates on long-term loans.

Investors could also come to fear that the Fed was "monetizing the debt," or printing money to fund budget deficits.

And, of course, both of these possibilities would be counterproductive.

Central banks utilize monetary policy, or the manipulation of the money supply, to control inflation. An inflated money supply in relation to the amount of goods and services in the economy eventually results in price inflation throughout the economy.

The Fed, like all central banks, prefers inflation to deflation. Yet despite all its best efforts, deflation still appears to be a threat.

Despite massive monetary stimulus, including $1 trillion in excess bank reserves, the Fed expects consumer prices to rise only about 1% this year and less than 2% per year over the next two years.

If deflation does indeed take hold, the Fed will pull out all the stops and take the most dramatic measures to thwart it. Deflation, a dangerous cycle of falling prices, could actually spur the Fed to undertake another round of massive asset purchases, despite the risks that it would entail.

The reality is that there are no good options. Every move will have undesired consequences.

Without a doubt, the next couple of quarters, and years, will be fascinating, to say the least.