The Federal Reserve meets later this month to determine the course of monetary policy. A couple months ago, you could have expected them to stay pat, to allow what was seen as a nascent recovery continue without tightening monetary accommodation or adding a boost. If anything they would have tightened by default, by wrapping up “Operation Twist,” the process of orienting its portfolio toward longer-term securities. Operation Twist was due to wrap up at the end of June. But that was before a troubling set of data that has increased talk of renewed Fed action:

Friday’s employment report, which found the economy added just 69,000 jobs — under half of what was expected — suggested that an already tenuous economic recovery might have lost steam.

With the Fed officially charged with maximizing employment and controlling inflation, those bleak numbers have analysts and lawmakers wondering if the central bank will act to jolt the economy.

“That’s the chatter,” said Andrew Busch of BMO Capital Markets. “At this point, they may be reassessing their outlook.”

The pressure heightened today when the Financial Times called for Fed action.

First, and most immediately, Ben Bernanke could reverse the hawkish drift at the Federal Reserve and announce a third round of quantitative easing at the next Federal Open Market Committee meeting, later this month. Pessimists have been forecasting runaway inflation since the start of the financial crisis in 2008. Clearly the markets do not agree. US Treasury yields continue to plummet – last week the 10-year bond hit a record low of 1.45 per cent. It is obviously impossible for the Fed to cut its discount rate to below zero. But if things deteriorate further, it could double its inflation target to 4 per cent.

FT does not assume that fiscal policy plays no role here. In fact, they state clearly that fiscal policy is currently dragging on US growth, at a time when the bond markets are begging for more borrowing, offering the lure of negative real interest rates. They also say that the looming fiscal cliff is dragging down growth prospects by increasing uncertainty (though I usually discount the uncertainty argument, in this case it’s a strong one; the idea that the Congress would risk a 4% hit to GDP through gridlock is appallingly likely). Basically they want Congress to do their job, and use counter-cyclical fiscal policy to increase overall demand.

But the Fed has the primary role, and because of obvious political factors, the only role that has a chance to work in the near term. The Federal Reserve has failed badly, joining other central bank failures during the aftermath of the financial crisis. They have consistently undershot their targets for inflation and employment, the only priorities they have. They have made 2% inflation a ceiling rather than a target that you can overshoot as well as undershoot. Ben Bernanke knows what to do – his work on the aftermath of Japan’s lost decade shows that. He understands that there are policy options for the Fed, even at the zero lower bound of interest rates. Most of them involve the expectations channel, to encourage higher inflation:

The Fed’s interventions have been limited and seemingly designed to ignore the powerful expectations channel; at no point have breakevens shown inflation expectations steady at even pre-crisis levels when expectations above pre-crisis levels are what the current situation demands. Despite the obvious importance of inflation expectations for recovery at the ZLB, the Fed has behaved as if it’s operating under a 2% inflation ceiling, rather than a target. It repeatedly stops pushing the economy forward as soon as it seems likely that the economic trajectory will carry inflation toward 2%. With plenty of slack remaining in the American economy, this strategy inevitably produces a return to disinflation at the slightest breath of trouble from abroad.

We know that this can work because Republicans are issuing warnings for the Fed to hold their fire. From the Hill article:

Republicans worry the Fed might read the report as a call to action.

“One of my fears is that the Fed feels an obligation to interject itself more into the economy, which I think is exactly the wrong thing,” said Rep. Kevin Brady (R-Texas), vice chairman of that panel. “I’m hopeful they don’t take this as a signal to intervene more.”

“I’m always concerned about what the Fed may do,” said Rep. Scott Garrett (R-N.J.). “They have, in my opinion, gone beyond their bounds.”

They obviously have a vested interest in stopping the Fed from acting. Add in the looming election and the still-palpable fear central bankers have of offending their peer group by expressing a higher inflation target, and the prospects for legitimate Fed action, on a level of expectations, are sadly remote.