SAN FRANCISCO FED PAPER WARNS ODDS OF RECESSION RISING / THE WALL STREET JOURNAL ( RECOMMENDED READING )

August 9, 2010, 4:12 PM ET.

San Francisco Fed Paper Warns Odds of Recession Rising.

By Michael S. Derby

The risk the U.S. economy could fall back into recession is on the rise.

A new report from the Federal Reserve Bank of San Francisco warns the economic outlook “is likely to deteriorate progressively starting sometime next summer.” Over the shorter run, the paper, written by Travis Berge and Oscar Jorda, argues the odds of falling into recession are relatively low. But over the next two years it appears the odds are only slightly better than even that an already-tepid recovery will continue.

The paper, published Monday, arrives just ahead of a potentially drama-filled Federal Reserve monetary-policy meeting. For many months now, market participants have gone into these gatherings fairly confident of the outcome, expecting policy makers to stick to their zero% interest rate stance amid pledges to keep interest rates low for an “extended period.”

But Tuesday’s Fed meeting has become fraught with uncertainty as the U.S.’s already-modest recovery looks to be running out of steam. While Fed chief Ben Bernanke has allowed there are additional steps the central bank could take to promote growth, he has appeared to be reluctant to employ them, adopting a patient stance in regards to the economy’s emergence from recession. Friday’s release of weak July jobs data, along with press reports, has helped reignite a market debate over whether the Fed will take fresh steps to help the economy, even though many economists disagree that anything exciting will happen.

Economists’ caution is in part motivated by the fact the Fed has no good options left to it, should it want to again stimulate growth. Interest rates can be cut no further. The Fed could again buy mortgage debt, but borrowing rates are already at historic lows. The central bank could buy significant amounts of government bonds, but it would risk its inflation fighting credibility by appearing to monetizing the debt. The Fed could in theory drive back into the economy the $1 trillion in bank reserves now on its balance sheet by suspending the interest it pays banks for that cash. But that, too, is problematic and there’s no guarantee banks would even want to loan that money out.

Policy makers face considerable uncertainty in the outlook. The paper states “at two years out, the odds of recession vary from almost three times more likely than expansion, to expansion being almost five times more likely than recession.”

The findings are based on data released as part of the Conference Board’s monthly leading economic indicators report. That series takes an array of existing numbers and seeks to divine the economy’s future trajectory. The June LEI was down, leading the private research outfit to warn of slower growth through the fall.

The San Francisco Fed paper said that even with the darkening outlook, there’s time to change course. “Economic policy can strongly influence the outcome,” the researchers said. While they did not offer any suggestions, they added, “the policies that are adopted today could play a decisive role in shaping the pace of growth.”

Berge is a graduate student at the University of California, Davis, and Jorda is a professor at the university and a visiting scholar at the San Francisco Fed.

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