ANALYSIS: The options are bad but inaction could pose a bigger risk, writes ROBIN HARDINGin Washington

THE US Federal Reserve’s meeting today is likely to be one of its most difficult and divisive since, well, last August.

Sharply weaker economic data in recent weeks, a new peak in the euro zone debt crisis and a credit rating downgrade have shaken confidence and could spiral towards a new recession.

Despite those recent shocks, however, policymakers still have reasons to think growth should pick up later in the year. Oil prices are now about $25 a barrel below their springtime peak; supply chain disruption from the Japanese tsunami should fade. Inflation is close to target.

Meanwhile, some Fed policymakers, have recently sounded notes of doubt about the amount of spare capacity in the economy and, by implication, the efficacy of monetary easing.

On the one hand will be an argument that doing nothing could make a bad situation worse. On the other will be deep reluctance to make decisions that take a year or two to affect the economy without more data.

The rate-setting Federal Open Market Committee has 17 members at present and struggles with abrupt changes of direction. To make matters even more difficult, much has happened since the Fed entered its pre-meeting purdah on August 2nd, so FOMC policymakers have had no chance to signal any change in views. The meeting will be unpredictable.

If the Fed does want to do something then its options are the same as they have been for the past couple of years.

First, the Fed could launch an “Operation Twist” on the yield curve, selling short-term Treasuries and buying long-dated bonds with the aim of driving down long-term yields. But the Fed considered buying longer-term assets last November and explicitly decided not to.

Second, the Fed could cut the rate it pays on banks’ excess reserves from 25 basis points to 10 basis points. That again is an option it explicitly rejected last November. Since then a new deposit insurance fee has driven down short-term market interest rates so cutting the rate on excess reserves might further hamper market functioning.

Third might be a third round of quantitative easing, or “QE3”. But imagine that the Fed bought another $600 billion of assets. That not only eases monetary policy today; if the action is credible it locks in easier monetary policy for the eight months it would take to carry out the purchases. If there is any doubt about inflation then the Fed will be reluctant to tie its hands so far into the future.

A similar objection applies to option four: a promise to keep rates lower for even longer than the current “extended period”.

The earliest such a pledge could be reversed is September. The Fed has signalled that the “extended period” means two or three meetings after that. An “extended period” pledge for the balance sheet, therefore, ties the Fed’s hands until early next year. If the FOMC does not expect to move in that time, it might judge that such a move has little cost – but then equally little benefit.

That leaves the final option: acknowledgement of the weaker economic data and a robust signal, delivered either today or in the chairman’s speech at Jackson Hole on the 26th, that the Fed is willing to act to counter any deflation risks that emerge.

The crucial point is that none of these options is especially appealing and those that are easier to do will not impart much stimulus. That means the greater risk to markets is that the Fed is cautious and does less than they demand – rather than riding to the rescue once again. – (Copyright The Financial Times Limited 2011)