A recent string of weak data has raised speculation the Fed may act to boost growth
The plodding US economy, meager job growth and market tensions over Europe's debt crisis will hang over Federal Reserve policymakers when they meet next week.
A recent string of weak data on the economy, from rising jobless claims to easing inflation as gasoline prices retrench, has raised speculation that the Fed may act to boost growth.
When the Federal Open Market Committee (FOMC) meets Tuesday and Wednesday, policymakers will know the outcome of Sunday's Greek election, which could see voters reject the country's EU-IMF bailout and force it to exit the eurozone.
The Fed will have a couple of days to monitor the reaction of the markets and European leaders to the vote, and assess the Group of 20 summit in Mexico to see how the world's major economies will deal with the eurozone debt crisis.
But economists are divided on whether there is enough evidence to convince the Fed to unleash new stimulus, and recent comments from central bank officials have produced mixed signals.
Investors appeared to have no such doubts, betting a Fed stimulus could be announced Wednesday that will pump liquidity into the markets. The Dow Jones blue-chip stocks ended Friday with its second consecutive day of triple-digit gains.
Nomura analysts said the FOMC decision "is a close call."
Recent statements by senior Fed officials, including Chairman Ben Bernanke, suggest that current economic conditions were unlikely to merit additional stimulus, they said.
"Nevertheless, risks to the US outlook have increased markedly and the FOMC may be reluctant to disappoint markets that seem to be anticipating additional accommodation."
The Nomura analysts declared they expected no new policy initiatives to be unveiled but the Fed would highlight rising risks.
Much of the markets' bullishness has been inspired by analysts suggesting the Fed would ride to the rescue.
"We believe economic and financial conditions have deteriorated enough to push the Fed into providing more stimulus," said Barclays Capital analyst Marion Laboure.
Laboure was among those predicting the Fed will extend its so-called "Operation Twist," a program of selling short-term securities to buy longer-term ones to push down long term interest rates that is scheduled to expire at the end of June.
She said the FOMC would want to extend Operation Twist by a few months "in order to give it more time to evaluate whether the recent slowing in job growth proves temporary or persistent."
Still, the Fed has little ammunition left in its toolbox after slashing its key rates to roughly zero in December 2008 to stimulate growth. In April the Fed said it would keep the ultra-low rates at least through 2014.
Some said the Fed could launch a third round of asset purchases, known as quantitative easing, that could pump hundreds of billions of dollars into the economy.
Fed Chairman Ben Bernanke kept his cards close to his chest in last week's testimony to Congress.
"We have made no decisions," he said when asked about the possibility of a "QE3".
However, he added, "I wouldn't want to take anything off the table at this juncture."
"Remember this spring, when quantitative easing was off the table?" said FTN Financial economists Chris Low and Lindsey Piegza in a research note.
"Well, the Fed meets next week and QE is back. We don't think they will opt to announce it just yet, but they will likely lay the groundwork even as they revised down expectations for growth and inflation."
In his testimony to lawmakers, Bernanke said the economy appeared poised to continue to grow at a "moderate" pace of about 2.0 percent over coming quarters.
The Fed will offer its latest projections on growth, inflation and unemployment Wednesday, with Bernanke set to hold a post-FOMC news conference.
Michael Gregory at BMO Capital Markets noted the murkiness of the economic picture, and said some of the ebbing momentum could be due to an unseasonably mild winter.
"One can't completely rule out an easing announcement next week or soon after, particularly if the FOMC places increasing weight on mitigating the escalating risks facing the US economy, and emanating primarily (but not solely) from Europe," he said in a client note.
UBS analysts agreed. "Further easing, through an extension of Operation Twist cannot be ruled out though we think they will wait this time around, perhaps guiding future policy more."