Europe debt crisis shadows Fed meeting on economy

WASHINGTON -- If the U.S. economic slowdown weren't enough to deal with, the Federal Reserve this week must consider a new threat: a resurgent European debt crisis that could imperil the global economy.

Financial markets have been gripped by fears that Greece will default on its debt and infect other economies. Those worries eased over the weekend as prospects for a rescue appeared to brighten. Still, the crisis has renewed fears that a Greek default could derail a still fragile economy in the United States and elsewhere.

When they meet today and Wednesday, Fed officials will likely discuss what to do to help shield the U.S. economy if Europe's crisis worsened. A Greek default would rattle global markets. Some analysts suggest that a panic would cause the Fed to intervene as it did during the 2008 financial crisis, when it lent billions to banks.

Even before Greece's crisis flared anew, the Fed was concerned about what chairman Ben Bernanke this month called a "frustratingly slow" U.S. economy. The slowdown is sure to seize much of the Fed's attention this week.

Since Fed policymakers last met in April, the economy has weakened. U.S. employers added only 54,000 jobs in May, the poorest showing in eight months. The unemployment rate is 9.1 percent. Most economists have downgraded their forecasts for hiring and growth for the rest of the year.

This week, the Fed is certain to leave a key interest rate at a record low near zero and will likely repeat its pledge to keep it there for "an extended period." Many economists say the slowdown means the Fed won't start raising rates until the summer of 2012, about six months later than many thought when 2011 began.

But one step the Fed has taken to try to stimulate the economy is set to end June 30: its $600 billion Treasury bond-buying program. The bond purchases were intended to lower rates on loans, lift stock prices and encourage spending.

Despite the new signs of weakness, there's little desire within the Fed to extend the Treasury-buying program. Critics have complained that the bond purchases raised the risk of runaway inflation while doing little to boost growth.

Bernanke has countered that creeping inflation from higher oil and food prices is likely temporary. And an updated Fed economic forecast due Wednesday is expected to show inflation under control.

Still, the Fed will probably trim its growth forecast for the full year while predicting a slight improvement in the second half of 2011.

At a news conference Wednesday, Bernanke will discuss the Fed's forecasts. It will be his second session with reporters under his new policy of holding regular news conferences for the first time in the Fed's history. What the Fed might do if the European crisis worsens will likely be on the agenda.

"There is no question that Europe will come up during the (Fed's) meeting," said Ted Truman, a former top Fed official now with the Peterson Institute for International Economics.

Truman and other economists said they expect no major announcements. Rather, they think Bernanke will signal that the Fed is following events in Europe and would coordinate a response with the European Central Bank should the crisis deteriorate.

Worries about Greek debt could spread to other European nations with heavy debt burdens, such as Ireland, Portugal, Spain and perhaps Italy. U.S. banks and the U.S. economy would be at risk, too.

"The European debt crisis has the potential to have as big an impact as the subprime mortgage crisis did in the United States," said Sung Won Sohn, an economics professor at California State University. "If it spreads to Spain and Italy, then the global economy could be facing huge problems."

When the European debt crisis first shook markets last year, the Fed renewed agreements with European central banks to supply dollars to them if they ran short. The central banks would lend the dollars to commercial banks. In return, the Fed would receive European currencies to hold until the dollars were repaid.

The Fed could also pursue stepped-up lending to financial firms through its emergency loan program, called the discount window. And it could resume the unorthodox loan programs it used during the financial crisis when credit froze up.

One involves emergency loans that go beyond the discount window. Another is backing for "commercial paper" -- the short-term loans that many U.S. companies use to finance needs from salaries to supplies.

European banks, through their U.S. subsidiaries, used the Fed's emergency loan programs. Those revelations have sparked criticism in Congress that U.S. taxpayers shouldn't be required to prop up European banks.

But others say that to safeguard the global financial system, the Fed must serve as a lender of last resort to any U.S. bank, including branches of foreign banks. They note that U.S. banks in Europe receive the same privileges from European central banks.

"The Fed sees the loans as doing its job to protect the U.S. financial system during a credit crisis," said David Jones, head of DMJ Economic Advisors, a Denver-based consulting firm, and author of several books on the Fed.