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The Federal Reserve is preparing to put its credibility on the line as it rarely has before by taking dramatic new action this week to try jolting the economy out of its slumber.

If the efforts succeed, they could finally help bring down the stubbornly high jobless rate.

But should the Fed overshoot in its plan to pump hundreds of billions of dollars into the economy, it could produce the same kind of bubbles in the housing and stock markets that caused the slowdown. Or the efforts could fall short and fail to energize the economy, leaving a clear impression that the mighty Fed is out of bullets - thus adding even more anxiety to an already dire situation.

The meeting of Fed policymakers Tuesday and Wednesday is set to be a defining moment of Ben S. Bernanke's second term as chairman of the central bank. Although he helped win the war against the great financial panic of 2008 and 2009, he now risks losing the peace if he fails to end the protracted economic downturn that followed.

Just two years after the world financial system nearly collapsed, it is again gut-check time for Bernanke.

"The greatest risk for the Fed in taking this action is that it could extend the economy's funk by giving a sense that either no one is in charge or that the people who are in charge can't get it right," said David Shulman, senior economist at the UCLA Anderson Forecast. "The whole psychology of that could leak back into the economy."

The Fed is charged by Congress with a twin mandate of maintaining maximum employment and stable prices, and it is failing on both counts.

The economy isn't in free fall. But as new data on gross domestic product affirmed Friday, the economy is mired in mediocre growth, too slow to bring down the unemployment rate. Inflation, meanwhile, is running about 1 percent, below the rate Fed officials view as optimal. When inflation is a little higher, it encourages consumers and businesses to spend money before it loses value.

"Phase one was to avoid a complete market meltdown and something akin to the Great Depression," said Mark Gertler, a New York University economist who has collaborated with Bernanke on academic research. "Phase two begins now and is in some ways trickier. . . . Once again we're in a situation where we have to use policies we haven't really experimented with."

The Fed is seeking to avoid the fate of Japan, where falling prices and weak economic growth over the past two decades have created a self-reinforcing economic stagnation. The hope is that by moving aggressively, such a cycle can be averted.

Fed watchers expect that the two days of meetings around a giant mahogany table will culminate this week in the announcement of around $500 billion in Treasury bond purchases and perhaps a statement indicating a willingness to make even more.

The intended benefits are already being felt. In anticipation of the Fed's action, investors have driven down mortgage rates, creating an extra incentive for people to buy a home. Expectations have also driven the stock market up, making Americans feel wealthier. And the dollar has fallen in value, making U.S. exporters more competitive, as currency investors reacted to an expected decline in U.S. interest rates.

But there's a danger that the bond purchases could work too well. For example, while a modest decline in the dollar could be good for the economy, a steep and disorderly drop could be disastrous.

And while Fed leaders want the inflation rate to be higher than it is now, if prices were to accelerate rapidly, that would be unwelcome.

There's also a risk that investors could view the Fed's program of buying Treasury bonds as a signal that the central bank essentially plans to fund U.S. budget deficits indefinitely by printing money. That could prompt interest rates to rise, stymieing the economic recovery.

Thomas M. Hoenig, president of the Kansas City Fed, appears likely to dissent from the Fed's decision this week. He said in October that such measures "could be a very dangerous gamble," given the risk of stoking asset bubbles, for instance in the stock market.


http://www.washingtonpost.com/wp-dyn/content/article/2010/10/31/AR2010103103818.html