The Federal Reserve on Tuesday may send a clear signal it is prepared to print more money to support a faltering economic recovery if necessary.
The central bank is widely expected to renew its vow to keep rates near zero for an extended period and markets will watch closely for signs officials are growing more concerned the recovery is at risk or that there is danger of falling into a damaging vicious cycle of falling prices and slowing growth.
Evidence the already sluggish recovery has lost momentum has shifted discussion at the U.S. central bank from exit strategies to whether the economy needs more backing, which would most likely come in the form of buying more longer-term assets.
A disappointingly weak report on employment in July, when the private sector added a meager 71,000 new jobs, adds weight to arguments in favor of more stimulus.
Fed Chairman Ben Bernanke told Congress in July the central bank is ready and will act if the recovery did not continue to move forward.
FED NOTES GREATER RISKS, VOWS ACTION IF CONDITIONS WORSEN
The Fed cut rates to near zero almost two years ago and has been promising to keep them extraordinarily low for an extended period at every meeting since March 2009. On top of that, it pushed nearly $1.7 trillion into the economy by buying longer-term Treasuries and mortgage-related debt.
Despite those actions -- some of the most aggressive central bank steps in history -- economic growth slowed to an annualized 2.4 percent in the second quarter of the year, barely enough to support new job creation.
Officials at their last meeting agreed to consider whether further stimulus would be appropriate if the outlook were to weaken appreciably.
July's jobs numbers may have forced their hand. They may decide to take the next step of acknowledging the softening in the recovery and making clear that they will act if conditions fail to pick up.
* Probability: Moderate to high.
* Market reaction: Stocks would drop. Equities may also hold the key for bonds. While lack of action might be negative for Treasuries they might benefit from safe-haven flows out of stocks. The dollar could decline because markets have begun to price in further Fed easing.
FED SAYS RISKS HAVE INCREASED, TAKES STIMULUS STEPS
The Fed could decide that the July jobs report shows the recovery failing to create sufficient jobs to sustain momentum and that its best bet is to err on the side of too much stimulus rather than too little.
The central bank could say it plans to reinvest maturing or prepaying mortgage-backed securities in its portfolio or that it will stop paying interest on excess reserves banks hold at the Fed to push down longer term interest rates and encourage banks to lend.
* Probability: Moderate.
* Market reaction: Stocks could rise or fall, depending on whether investors view it as a signal of a worsening outlook or a welcome sign the Fed is back in play. Bonds would likely rally on the prospect of asset purchases that could include Treasuries or mortgage-backed securities. Any gains in Treasuries could be short-lived if it inspires enough confidence in the stock market to improve risk appetite. The dollar could weaken further.
FED NODS TO RISKS, BUT DOESN'T REFERENCE FURTHER STEPS
A view could prevail at the Fed that some of the weaker recent data represents a temporary setback for the recovery -- a soft patch -- but that the economy will resume a more vigorous pace of growth before long. Officials may note some softening but will go no further than repeating oft-stated language saying they will employ policy tools as necessary to promote economic recovery and promote price stability.
* Probability: Low to Moderate
* Market reaction: Stocks would drop. Bonds drop on disappointment over lack of asset purchases that include Treasuries, though the extent of stock market losses could limit the drop in bonds. Dollar might rise on view Fed easing is over or decline on growing sense that what the Fed is doing isn't working.
(Reporting by Mark Felsenthal; additional reporting by Burton Frierson in New York; Editing by Paul Simao)