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The U.S. Federal Reserve is on deflation watch amid heightened risks that the world's largest economy could slump back into recession.

With almost every indicator this summer showing that the recovery is sputtering, the central bank's policy committee said Tuesday that it will keep the taps of monetary stimulus open for the foreseeable future, rather than backing away from the steps it took to fight the financial crisis. The shift caused North American stocks to rally as investors reacted favourably to the signal that the Fed was prepared to prop up the economy and financial markets.

After a one-day meeting in Washington, the Federal Open Market Committee (FOMC), led by Fed chairman Ben Bernanke, left the benchmark interest rate at 0 to 0.25 per cent and reiterated that borrowing costs in the United States would remain at "exceptionally low" levels for an "extended period" to offset weaker-than-expected economic growth.

More significant, central bankers said they would keep the value of government-backed securities on the Fed's books at the current level of about $2-trillion (U.S.). The decision suggests that policy makers believe the recovery has weakened to the point that even the suggestion of restricting stimulus is hurting confidence. That risks a self-defeating deflationary spiral, where companies lower prices to win sales, which only corrodes profits and prevents hiring.

The $2-trillion stockpile is a legacy of the Fed's most aggressive efforts at fighting the financial crisis. To replace private demand that fled to the sidelines, the Fed bought Treasuries and debt and mortgage-backed securities issued by housing agencies Fannie Mae and Freddie Mac, in a bid to flush money into the financial system and keep interest rates low.

No central banker is comfortable being such an active player in financial markets, and Mr. Bernanke is no different. Earlier this year, he let the purchasing programs run out and said he would shrink the Fed's balance sheet back to a reasonable size by declining to replace the securities after they matured.

But with the recovery faltering and financial markets in a volatile state, Mr. Bernanke was under pressure to do something to restore confidence in the economy. He chose to reverse course on his plan to get the Fed out of the business of active investing. The Fed said Tuesday that it will continue to roll over its Treasury holdings, rather than let them lapse. It also will use the principal on its holdings of Fannie and Freddie debt and mortgage-backed securities to reinvest in Treasuries with terms of two to 10 years.

"The pace of recovery in output and employment has slowed in recent months," the 10-member FOMC said in a statement. While the Fed said it continues to anticipate "a gradual return to higher levels of resource utilization in the context of price stability," policy makers acknowledged that "the pace of economic recovery is likely to be more modest in the near term than had been anticipated."

The Fed's key policy makers met for the first time since June and were divided over whether the U.S. economy is at risk of sliding into a deflationary funk of the kind that has plagued Japan for the better part of two decades. James Bullard, president of the Federal Reserve Bank of St. Louis and a member of the FOMC, is the most vocal of this camp, saying in a speech on July 29 that the Fed should resume purchasing securities to pump money into the financial system and keep borrowing costs low.

On the other side is Tomas Hoenig, the president of the Kansas City Fed, who has argued for months that the economy is growing steadily, if unspectacularly, and that the Fed should begin limiting its stimulus or it will risk stoking rapid inflation once business and investor confidence takes root.

The arguments voiced by Mr. Bullard appeared to carry the day on Tuesday, as every member of the FOMC except Mr. Hoenig endorsed the decision to continue to carry a large balance sheet. Mr. Hoenig, as he has done at the previous four meetings, said the pledge to keep interest rates low for an extended period is no longer necessary and "limits the Fed's ability to adjust policy when needed."

Now that it has sided with those who perceive deflation as the bigger risk to the economy, Mr. Bernanke and the FOMC will face questions about whether they are willing to further expand the Fed's balance sheet if economic conditions worsen.

One market watcher wondered about the Fed's direction. "Our view is that simply reinvesting the proceeds from maturing agency securities will not provide much additional stimulus and, should the outlook continue to worsen, then the Fed will likely initiate a new round of asset purchases," Michael Gapen, an economist at Barclays Capital in New York, said in a note to clients.

The FOMC struggled to find much good to say about the economy. The committee stressed that it still anticipates economic growth, not a slip back into recession. Still, central bankers conceded that the economy is constrained by high unemployment, modest income growth, lower housing wealth and tight credit.

That's not the type of environment that breeds inflation. Prices, which increased 1.4 per cent in June from the year earlier, are well off the Fed's unofficial target of a 2 per cent annual increase.

"Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time," the FOMC said.

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