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Don't look to the Fed for a rescue

August 9, 2011: 9:41 AM ET

There are not many options left for our nation's lender of last resort. Expect strong words from Bernanke & Co. without strong actions.

FORTUNE – When Federal Reserve policymakers meet today, they'll face a starkly different set of conditions than at their last meeting less than two months ago.

Ben BernankeIn recent weeks, a spate of bad economic data has rattled markets. The economy grew by only 1.3% during the three months ending in June and revisions to previous quarters show that GDP barely grew at all during the first half of this year. The U.S. lost its impeccable triple-A credit rating from Standard & Poor's following a political showdown that almost drove the nation to the brink of default. Meanwhile, as problems in southern Europe intensify, U.S. stocks plummet – an eerie reminder of the apocalyptic days of the 2008 financial crisis.

These are scary times indeed. As the agency charged with promoting economic growth and financial stability, the Fed will be expected to play doctor – again – to revive the tepid recovery.

But officials will likely hold off on any dramatic actions, at least today. After all, doing so might look as if they're responding directly to the downfall of equity prices, an approach that has been heavily criticized.

This isn't to say that the Fed will sit idle, either. Chairman Ben Bernanke will probably acknowledge that the economic outlook now appears decidedly more challenging than it did when the Federal Open Market Committee met in late June. If the Fed does decide to take immediate action, it will likely signal to markets that the federal funds rate, balance sheet or both will remain even more stimulative for an extended period.

Admittedly, the Fed is running out of options. Following the financial crisis, Congress spent billions of dollars on everything from roads to solar panels to bailing out troubled banks through a stimulus of more than $700 billion. But with government spending being a politically divisive issue, we can probably scratch another spending package out of the picture.

The Fed could also cut interest rates, with the hopes that it would spur more spending by making it cheaper for consumers to borrow money. But rates have been at nearly zero for many quarters now and can't possibly fall any lower.

Then there's the last-resort: QE3, a large-scale program of bond purchases that would effectively pump hundreds of billions of dollars into the economy. The Fed has done this not once, but twice since the bust of Lehman Brothers. Though calls for another round of quantitative easing has been getting louder, taking such a step – at least today – isn't likely, since previous efforts failed to spur much economic growth. What's more, it might actually even backfire by signaling that the economy is in worse shape than the Fed thought.

And while last week's downgrade of U.S. government debt might seem unnerving, that alone isn't going to compel the Fed to take such bold actions. At least not immediately. After all, the downgrade is arguably more a reflection of political stalemate in Washington than a fiscal breakdown (although the two are interrelated). And it's really not the Fed's job to referee Republicans and Democrats or even help ease the nation's debt woes. Putting the government's finances in order is the job of Congress.

"I don't think the downgrade means much at all," says Josh Feinman, Deutsche Bank's global chief economist. "It's a sideshow really."

Still, investors are unnerved. The big worry is that the downgrade on U.S. government debt could send interest rates soaring, raising borrowing costs for everything from student loans to home mortgages. And what do investors do when they get nervous? Buy up U.S. government debt – ironically, the very things troubling markets and Washington lawmakers.

There's a different scenario playing out at the central bank in Europe. Just as the ECB has come to rescue debt-ridden Spain and Italy by purchasing its bonds, the Fed has been propping up the U.S. economy in similar fashion. The difference is that the ECB is directly trying to solve the region's debt woes – which, if only symbolically, cements the central bank's role as the institution with the primary responsibility of solving governments' spending problems.

That, in itself, may come with all kinds of risks.

The question now is would the Fed want to land a similar job?

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About This Author
Nin-Hai Tseng
Nin-Hai Tseng
Writer, Fortune

Nin-Hai Tseng covers economics and finance. Before joining Fortune, Tseng was a reporter at The Orlando Sentinel and a public affairs associate at GE. She holds an MPA from Columbia University and a BS in Journalism from the University of Florida. She lives in New York City.

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