NEW YORK (CNN/Money) - They're probably going to leave interest rates alone Tuesday, but Federal Reserve policy-makers will need to use some fancy footwork to strike the right pose between concern about recent ugly economic data and hope about the economy's long-term prospects.
The Federal Open Market Committee (FOMC), the central bank's policy-making arm, meets Tuesday to discuss interest rates and the economy. Most analysts think the Fed will leave rates alone -- only two of 22 economists surveyed by Reuters expect a cut -- but it's unclear what sort of statement the Fed will make about the economy's prospects.
Usually, the central bank says the risks to the economy are tilted towards weakness, tilted towards inflation, or balanced between both headaches. When the policy-makers met in March, they punted, saying the U.S.-led war with Iraq was making it difficult to get a read on the economy.
Now that the war's over, it seems unlikely the Fed will keep dodging the question, and Fed Chairman Alan Greenspan, in congressional testimony last week, promised the central bank would tackle the problem Tuesday.
Though Greenspan and other Fed officials have said they think the economy is poised for a rebound, it seems unlikely they can ignore recently dismal economic data, most notably a drop in manufacturing activity and the loss of 525,000 jobs in the past three months, the kind of labor-market cuts usually seen only during recessions.
"I suspect they will not have a neutral bias; they will indicate risks are on the downside," said former Fed economist Wayne Ayers, now chief economist at Fleet Boston Financial. "I think we will, on the production side, see better numbers in the second half of this year, but I don't expect any convincing improvement in the labor market before early next year."
When the Fed wants to goose the economy, it cuts rates, making borrowing cheaper and encouraging spending. When it wants to tap the economy's brakes to fend off inflation, it raises rates.
The Fed cut rates 11 times in 2001 in an effort to battle the effects of a recession that began in March of that year and likely ended before 2002. Economic growth went on a roller-coaster ride for much of 2002, and a dip in the fall inspired the Fed to make yet another cut in its target for the fed funds rate, the central bank's key overnight bank lending rate.
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The Fed's current target for the rate, 1.25 percent, is the lowest level in 41 years. Some observers think the Fed is reluctant to cut rates again since the bankers want to keep some ammunition in reserve in case of some unforeseen shock, such as another terror attack.
And some Fed officials have talked about the central bank having an emergency plan to employ unusual methods, such as buying long-term bonds to manipulate long-term rates, as an alternative to old-fashioned rate-cutting.
"There's a growing effort within the Fed to look for other ways to add liquidity into markets and to sustain the interest-rate-led growth we've had," said former Fed economist Lara Rhame, now at Brown Brothers Harriman. "I think they are going to move to a bias to ease policy again, but I'd look for the ease somewhere else. It won't be a rate cut."
The glass half full?
Some economists think the Fed will adopt a neutral view of the economy. That would certainly be a happier headline to read in Wednesday morning's papers, possibly soothing the nerves of gun-shy business executives, who will need to start spending and hiring for the economy to pick up some steam.
It could also keep markets from hoping too much for a rate cut in June. Though only eight of the 22 economists surveyed by Reuters expect a cut at the Fed's June 24-25 meeting, the fed funds futures contract, an indicator of what traders are betting the Fed will do, is pricing in a strong chance of a June cut.
What's more, not all the recent economic news has been bad. Consumer confidence has rebounded and the nation's purchasing managers said Monday that the service sector -- the economy's biggest employer -- improved in April.
Greenspan and most economists think already-low interest rates, falling oil prices, lean corporate inventories and work forces, a tax cut later this year and the falling dollar are a potent cocktail for economic growth in the second half of the year -- if not sooner.
"We should start to see better numbers in the May data. If we don't see improvement, it would be much more worrisome than the recent weakness and might inspire the Fed to cut in June," said Barclays Capital chief economist Henry Willmore. "My own view is that we will see better numbers."
And some economists aren't sure another Fed rate cut will do the economy much good anyway. Certainly, low rates have already fueled automobile purchases, a mortgage-refinancing boom and a red-hot housing market, all of which have helped keep consumers spending.
That spending, which fuels more than two-thirds of the economy, has in turn kept the dreaded "double dip" recession at bay -- in that sense, the Fed's 12 rate cuts have performed exactly as intended.
Further rate-cutting would seem to have less impact, and some economists worry it could even do some harm, with consumers already defaulting on mortgages and credit card debt at record levels.
"To me, a cut now would just entice households to go deeper into debt, and that game has a limit to it," said Paul Kasriel, senior economist at Northern Trust in Chicago.
Kasriel added, however, that his was the minority view. The risk that consumers, saddled with an ever-growing debt load, could see jobs disappearing and decide to take a break from spending, triggering another recession, would usually be enough to get the Fed to cut, he said.
"The only reason they won't cut is because Alan Greenspan suggested he wasn't yet in the mood to cut," Kasriel said. "He's probably a Cubs fan as well -- they always say, 'Wait 'til next year.' In this case, Greenspan says, 'Wait 'til the second half.'"
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