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To rescue economy, Fed gets ready to twist and shout

After pumping $2 trillion into the system, pushing interest rates to the floor and making a bold promise to keep rates low for two years, the Federal Reserve is running out of options.

Now, with the U.S. economy flagging and the European financial system under siege, it’s time to twist and shout.

“It's a pretty critical meeting for the Fed,” said Jeffries market strategist David Zervos, a former Fed adviser. “It's one of those meetings where we know there's going to be a change. It's not just the perfunctory ‘Let's meet and greet and let's make a statement that we're vigilant and we know what we're doing.”

With economic indicators flashing red around the world, U.S. central bankers are scrambling to try to revive growth. Most of their most effective tools have already been deployed. Deep cuts in short-term interest rates have slashed the cost of money for banks to near zero.

Since the housing market collapsed in 2007, the U.S. central bank has siphoned roughly $2 trillion worth of bonds - much of them backed by shaky mortgages - out of the banking system.  More recently, Fed policy makers took the highly unusual step of promising to keep rates low for the next two years. Now, there's little left to do but wait and hope the economy begins to heal on its own.

But Fed officials are determined to show the world that the central bank still has a few tricks up its sleeve. Fed watchers say two of them are likely candidates for the Fed’s official policy announcement when the meeting concludes on Wednesday.

Doing the Twist
One of those moves, dubbed "Operation Twist," would represent a reshuffling of the bonds the Fed already holds in its vaults. By exchanging short-term notes for longer-term bonds, the Fed is hoping to push long-term rates even lower than the already bargain basement rate of roughly 2 percent.

Operation Twist won't change the amount of money available for lending; when the Fed buys longer term-debt (adding dollars to the system) it's expected to offset those purchases by selling short-term debt (taking the cash back.) The goal is to lower the overall level of interest rates - not unlike a homeowner swapping higher-rate credit card debt for a lower-rate home equity loan. 

(The move, first tried in 1961 when the dance was invented, aims to "twist" the typical relationship between rates on short- and long-term debt.)

Lowering rates typically pushes bond prices higher, so anyone who already owns a Treasury bond makes a little money. Lowering rates also tends to prompt investors to look for higher yields from other investments, such as stocks, which helps support stock prices.

But the financial markets are already widely expecting Operation Twist. So even if the central bank follows through, it would have little or no impact, according to Nigel Gault, a senior economist at IHS Global Insight.

“The Fed would have to seriously overshoot what the market is expecting to have any impact on long term yields,” he said. “This is not a big deal in terms of where long-term rates are. It makes a marginal difference. It's not a game changer."

Low Rate Shout-out
Fed watchers say the central bank may also beef up its typically opaque policy statement to add more weight to its announcement – call it “Operation Shout.” Fed officials recently amped up the wording of their usually bland communiqué with a pledge to keep rates low for the next two years. To take that pledge a step further, Fed officials could link that promise to specific targets for inflation or the jobless rate.

The odds of the Fed setting those targets are lower, say Fed watchers, because the central bankers would have to agree on the specific targets before they made them public. That consensus would be difficult to reach.

Beyond twisting and shouting, the Fed is running out of moves to bust out. One could involve cutting or eliminating the interest it pays banks to keep money parked in its vaults. The hope is that doing so would encourage banks to put those reserves to work by increasing their lending.

But bankers say they’re just not seeing the demand for more loans. That’s not likely to change as long as business leaders face major uncertainties about the health of U.S. global economy, the unraveling of Europe and ongoing deadlock over U.S. tax policy.

“I don't think liquidity or rates are the issue in the economic recovery,” Kimberly Clark CEO Thomas Falk told CNBC. “I think there's plenty of money out there, and rates are at historic lows in my lifetime. There’s just not much demand.”

As the U.S. economy falters, Europe has presented Fed officials with an even greater challenge. Last week, the U.S. central bank joined others around the world to open their "dollar windows" by offering to swap as many dollars for euros as the European banking system needs to fund its dollar-denominated loans. The U.S. banking system is believed to be relatively well ring-walled from the potential fallout of one or more European bank failures. But it's impossible to predict just where the damage might be inflicted from another Lehman Brothers-like financial panic.

U.S. Fed officials are relying on their European counterparts of head off disaster. But the European Central Bank is badly split over how to deal with the crisis. It also has much less capital to work with then the U.S. central bank.

The historic strains on the system in the U.S. and the cloudy economic outlook have also left Fed policy makers divided on how to proceed. Some “hawks” on the policy-setting committee fear that too much easy-money policy will spark a surge in inflation that will be difficult to contain. On the other side of the table, the "doves" argue that the weak U.S. economy and banking crisis in Europe argue for more aggressive moves. 

CNBC's Steve Liesman with a look at the Fed's options to stimulate the economy. With Steven Rattner, former White House auto czar, and Hans Olsen, Barclays Wealth.