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WASHINGTON (Reuters) - The Federal Reserve's carefully scripted decision to raise interest rates last December, and begin a return to "normal" policy, may now become a nightmare for the U.S. central bank if an economic downturn forces a return to unconventional methods.
Fed chair Janet Yellen told lawmakers this week she was studying ways to "be prepared" in the event the current slide in world stock markets, concern about financial sector stress, and slowing economic growth all translate into a recession or another financial crisis.
But Yellen said the policy tool of negative interest rates, now favored by some foreign central banks offers no sure bet for the U.S. economy.
"We need to consider the U.S. institutional context. They are not automatic...We previously studied them and decided they would not work well," Yellen told the U.S. Senate Banking Committee on Thursday, when asked whether the Fed was "out of ammunition" to fight a new downturn.
After mistakenly raising interest rates briefly in 2011, the European Central Bank turned to negative interest rates last year as a policy tool, and the Bank of Japan followed suit in January in another bid to avoid deflation and promote economic growth.
Yellen's two days of testimony to the U.S. Congress this week, a semi-annual appearance mandated by law, brought home the dilemma the Fed faces.
The plan to return to "normal" policy was one Yellen engineered slowly during her first two years in office, but was delayed until December last year partly because Fed officials recognized they had little maneuvering room to fight any fresh downturn.
So far this year U.S. economic data points to continued recovery, with steady job growth and domestic consumption giving the Fed reason to stick to the plan for "gradual" interest rate rises this year, announced on Dec. 16 last year.
Given market concern about slowing Chinese economic growth, slumping slumping commodity and stock prices recently, Yellen did acknowledge though that U.S. financial conditions are now much tighter than the Fed expected when it enacted an almost symbolic quarter point interest rate hike last year.
The Fed's perceived miscalculation about the length of the oil price slump, the strength of the U.S. dollar, and the impact of weakening Chinese economic growth have led markets to doubt that inflation will return to the Fed's 2.0 percent target.
A return to quantitative easing or bond buying to counter another recession would face doubts though also. The initial round of U.S. quantitative easing is thought to have helped battle the financial crisis when it was launched in Dec. 2008, but even sympathetic policymakers have questioned how much impact two subsequent rounds of bond buying had on jobs, investment and economic growth.
Beyond those tested tools, "the policy options for the Fed are not great," said Jon Faust, a Johns Hopkins University economics professor and former adviser to the Fed's Washington-based Board of Governors.
Quantitative easing "made a lot of sense" as an effort to prime a nascent economic recovery, Faust said, "but that is not the same as turning an economy that is heading down."
With short term U.S. interest rates still so near zero, the standard monetary policy tool of lowering rates is also unlikely to work. Other options, such as the direct lending programs used during the 2008 crisis, might stretch the Fed's legal authority.
"There are limits to what monetary policy can do," said John Cochrane, a senior fellow at the Hoover Institution at Stanford University. "There is a world market pushing for lower interest rates that is very hard for the Fed to fight."
It is still too early for the Fed to declare defeat though, said David Stockton, the Fed's former research director and now a fellow at the Peterson Institute for International Economics.
The Fed's next monetary policy meeting will be held on March 15-16 when policymakers issue fresh economic forecasts and Yellen holds a press conference.
Given the perceived limits on what central banks can now do, and the political limits on any likely fiscal response to a recession, "we are going to be in a situation where you are pricing in greater concern about negative outcomes than the benefits of positive outcomes," Stockton said.
"We would be entering a much more perilous situation if we suffer an outright downturn at this point."
Reporting by Howard Schneider; editing by Clive McKeef