How much would the economy have to weaken for the Federal Reserve to try to push borrowing costs even lower?
That question will loom over Capitol Hill this week as Fed Chairman Ben Bernanke delivers his semi-annual testimony on monetary policy to Congress on Wednesday and Thursday.
The answer may rest, as it so often does, on jobs. If a recent softening in a range of economic data is matched by greater unemployment, the U.S. central bank may be forced to take action, even if its room for maneuver is now limited.
Lawmakers, keen to appear proactive ahead of mid-term elections in November, will try to coax Bernanke into backing their respective agendas, with Republicans pressing him on the budget deficit and Democrats on the need for more stimulus.
He will probably stop short on both counts, preferring instead to dwell on the monetary policy options available to the Fed if the economy were to worsen appreciably.
Bernanke faces the difficult task of convincing Congress the Fed is not powerless to deal with slower growth, without appearing so worried about the outlook as to suggest further easing may be imminent.
At this moment, he and the (Fed's policy) committee are not prepared to do anything. They feel they've used up most of their bullets, and they don't want to go there, said Kevin Logan, chief U.S. economist at HSBC.
It will be a fine line between not showing any panic or undue concern but at the same time making it clear that they're watching this and will do what's necessary.
There are good reasons for the Fed to be reluctant. A renewed easing would represent a big about-face for a central bank that just a couple of months back was avidly discussing its exit strategy from extraordinary stimulus measures.
Then there is the issue of effectiveness. With interest rates effectively at zero, can the Fed really do more?
Sure. It could resume buying longer-term Treasury debt or mortgage-related assets, extending a controversial program that saw the Fed take on more than $1.5 trillion of these assets.
It could also reduce the amount it pays banks to park their excess reserves at the Fed. It could even, at an extreme, target a specific yield level on Treasury notes, a possibility broached by Bernanke in a 2002 speech on battling deflation.
DIVIDED WE STAND STILL
But none of these options are very attractive. With asset purchases, or even yield targets, it is unclear how much bang the Fed would get for its newly minted bucks. The same applies to interest on reserves. If the problem is lack of demand for credit, steps aimed at encouraging banks to lend more may not do any good.
Some regional Fed officials have a natural dislike of buying mortgage debt, believing it comes too close to crossing the line into a fiscal policy that benefits one sector of the economy over others.
Such concerns raise the bar for any Fed action to a high level. Fed Governor Kevin Warsh indicated as much last month when he argued further expansion of Fed credit to the banking system, already at a record $2.3 trillion, would need to be subject to strict scrutiny.
It would require a heck of a lot more, said Paul Ballew, a former Fed staffer and now chief U.S. economist at Nationwide in Columbus, Ohio.
U.S. unemployment currently stands at 9.5 percent, while inflation remains quite tame, and does not appear to be a near-term threat. Bernanke will have to be careful not to spook investors into believing things are actually even worse than they thought.
If they signal they're going to do something, that could have an adverse effect on financial markets, Ballew said.
The Fed faced some tough times during the financial crisis that began in the summer of 2007 and reached fever pitch in 2008. But from a policy standpoint, the current period may be even tougher, Ballew says.
The uncertainty is creating rifts within the Fed's policy-setting Federal Open Market Committee. The minutes of the last FOMC meeting suggested as much.
Some members were worried about deflation and were keen to talk about what steps the Fed might take in the event of further economic deterioration. Others, in contrast, were still pushing to tighten financial conditions by beginning asset sales in the near term.
One official, Kansas City Fed President Thomas Hoenig, continues to push for a near-term rate increase to thwart inflation threats.
Yet with so many Americans dealing with foreclosures, unemployment or both, lawmakers are likely to press hard on the issue of what more can be done to bolster growth.
A key impediment to further easing is the fear among policymakers that markets will see the Fed as monetizing the U.S. government's budget deficit. So if Congress does want the Fed to act, it better not push too hard.