Europe debt crisis shadows Fed meeting on economy

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. Other European nations with heavy debt burdens, such as Ireland, Portugal, Spain and perhaps Italy, could be at risk, too.

When they meet Tuesday and Wednesday, Fed officials will likely discuss what they might do to help shield U.S. banks and a still fragile U.S. economy if Europe's crisis worsened. 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.

"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."

Once its meeting ends Wednesday afternoon, the Fed will issue a statement that's likely to say it will leave a key interest rate at a record low near zero for "an extended period." Many economists say the U.S. slowdown means the Fed won't start raising rates until the summer of 2012, about six months later than many thought when 2011 began.

Later in the afternoon, the Fed will update its economic forecasts. And then Chairman Ben Bernanke will hold a news conference — his second session with reporters under his new policy of holding regular news conferences for the first time in the Fed's history.

When the European debt crisis first surfaced in the spring of 2010, Bernanke told Congress that it would likely have only a modest effect on the U.S. economy as long as Wall Street stabilized. He cautioned that the Fed would monitor the developments and their potential effects on the U.S. economy.

At the time, the Fed opened a program to ship dollars overseas to pump more cash into the financial system and give European central banks enough dollars to lend to commercial banks. In return, the Fed received European currencies to hold until the dollars were repaid.

The Fed could resume that effort if the European crisis worsened. It 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.

Former Fed Chairman Alan Greenspan said in a television interview last week that the likelihood of a Greek default is so high "you almost have to say there's no way out." Greenspan suggested that the crisis potentially could push the United Sates into a second recession.

Still, economists say they expect no major announcements from the Fed this week. 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.

Among the unconventional loan programs the Fed could resume, 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.

Even before Greece's crisis flared anew, the Fed was concerned about what Bernanke this month called a "frustratingly slow" U.S. economy.

Since Fed policymakers last met in late 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.

One step the Fed had 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 the 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.