World crisis: Will the Federal Reserve act?

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The Federal Open Market Committee, also known as the FOMC, meets Tuesday for the last time this year, and Fed watchers expect a lot of talk but no action from the rate-setting committee.

Though the Federal Reserve’s meeting is sure to be packed with nuanced discussions of domestic and international monetary policy in this tumultuous time, no significant changes or announcements are anticipated from the December meeting.

If anything unusual comes out of the FOMC this time around, it could be in the form of a long and comprehensive statement following the meeting in an effort to increase transparency and enhance communication.

Economy shows signs of life

Despite forecasts of a double-dip recession, the economic data following the last Fed meeting have been generally positive, which portends a quiet Fed meeting while the world waits with bated breath as the European debt crisis plays out.

“If you look at the Beige Book and the pieces of information coming out on the U.S. domestic economy, things seem to be moving in a positive direction,” says Robert A. Eisenbeis, chief monetary economist at Cumberland Advisors in Sarasota, Fla., and former executive vice president of director of research at the Federal Reserve Bank of Atlanta.

Additionally, the Bureau of Labor Statistics released the nonfarm payrolls for November, which showed a decrease in the unemployment rate. By most accounts, it was better than anticipated.

“We’re starting to see turnarounds in a lot of things, and that is encouraging. That limits the possibility of them announcing some big purchasing plan, though they will do behind the scenes whatever they need to do to facilitate credit markets,” says James Kee, president and chief economist at South Texas Money Management in San Antonio.

Eye on Europe

Though the U.S. economy has recently seemed to regain some footing, the situation in the eurozone has dragged on. That has prompted fears of contagion in the absence of a workable deal to resolve the crisis.

To prevent that potential outcome, six central banks banded together Nov. 30 to provide liquidity to European banks through temporary dollar-swap arrangements, in effect briefly making it cheaper for European banks to borrow U.S. dollars.

As the swap lines pose little risk to the Federal Reserve itself or to the U.S., the international efforts by the central bank could curtail any potential fallout from foot-dragging on the part of the Europeans.

The big risk is a disorderly default or dissolution of the euro or the European Union, but the desire to bail out the neighbors across the pond is limited.

“They may have a little window-dressing getting over the year-end, maybe an additional swap arrangement to handle any liquidity needs at the end of the year, but I think, other than that, you won’t be seeing much else from the Fed,” says Wilmer Stith, CFA, portfolio manager of MTB’s Intermediate-Term Bond Fund.

Clarity in communications

Back on the home front, minutes from the November meeting of the FOMC showed the committee grappling with the issue of using communication to sharpen monetary policy.

The committee discussed specifying long-term inflation goals or “providing additional information to the public about the likely future path of the target federal funds rate,” the minutes show.

In an effort to foster increased transparency in addition to clearly telegraphing future goals and expectations, the statement released following the Dec. 13 Fed meeting may be longer and contain new clues about the philosophies of FOMC members.

“Now that global financial strains are becoming more commonplace in the discussions, I think the Federal Reserve feels an increased need to explain and amplify what their mandates are and how it takes policy in with respect to its mandates,” says Alan Gayle, senior investment strategist and director of asset allocation at RidgeWorth Investments in Richmond, Va.

Future MBS purchases remain a possibility

Even though the economy more resembles a car struggling to get out of a ditch than a sinking ship, that has not precluded the possibility of further stimulus in the form of security purchases down the road.

In a recent speech, Janet Yellen, vice chair of the Fed’s Board of Governors, indicated the Fed is comfortable maintaining a highly accommodative stance as long as inflation remains relatively stable. If necessary, more easing could come in the form of communications explicitly delineating economic targets they would like to see before raising the federal funds rate, ” or through additional purchases of longer-term financial assets,” she said in the speech Nov. 29 at the Federal Reserve Bank of San Francisco.

If there were to be another round of securities purchases in the future, the Fed may try to target the home mortgage area, which it views as a significant headwind to the financial recovery.

The staff forecast for the economy will also be of interest, though the in-depth discussion will only be revealed in the minutes, released three weeks after the meeting. Even so, no great surprises are expected.

“They have already lowered their economic forecast for the rest of 2011 and 2012. I suspect that they will probably stick with those forecasts,” says Gayle.

“There will probably be some discussion about the extent to which U.S. banks will be potentially exposed to the weakness in the European financial system,” he says. “So far, the Fed has concluded that the risk is not meaningful. It will probably maintain the current policy and will probably take more steps to explain policy and long-term outlook.”