Markets overnight succumbed to a fresh bout of nerves as they waited anxiously to hear what US Federal Reserve boss Ben Bernanke will say in his big opening address at the Fed’s annual meeting in Jackson Hole tonight.

The atmosphere at this year’s meeting is likely to be particularly intense. The gathering — which brings together top Fed officials, along with foreign central bankers and select academic experts — is taking place against a gloomy economic backdrop. The US economic recovery is painfully slow, unemployment remains stubbornly high, and markets are increasingly coming to fear deflation.

The US Fed, along with central banks around the world, has already taken extraordinary steps to try to foster economic activity. It has cut interest rates to zero and promised to keep them low for an extended period. It has also purchased trillions of dollars in mortgage backed securities and treasuries in order to push down long-term interest rates.

The big question it now confronts is whether it should engage in even more quantitative easing — printing more money and buying even more long-term securities — in a further attempt to kick-start the economy.

The trouble is that many economists are beginning to worry that the US economy is so weak that it’s now ensnared in a liquidity trap, in which monetary policy stops working.

A liquidity trap arises when people are so despondent about the economic outlook and the state of their own balance sheets that further cuts in interest rates no longer spur them to take on more risk. Banks are simply unwilling to lend more, companies resist investing more, and consumers can’t be persuaded to spend more. In this environment, monetary policy becomes ineffective — it’s like pushing on a string.

And the atmosphere of this year’s Jackson Hole gathering is particularly charged following an article in the Wall Street Journal earlier this week. The article detailed the rift among top Fed policy makers at the last meeting of the Federal Open Market Committee (FOMC) over whether the Fed should start to reinvest the proceeds of its huge $US2.05 trillion stock of mortgage debt and US Treasury holdings.

The WSJ article pointed out that the Fed’s balance sheet is shrinking faster than expected, because Americans are taking advantage of record low mortgage rates to refinance their mortgages. As a result, the portfolio of mortgage-backed securities held by the Fed is shrinking. In March, the portfolio was expected to contract by more than $200 billion by the end of next year. The latest estimates saw the Fed’s balance sheet shrinking at almost twice that rate. That meant that the modest tightening implied by letting the Fed balance sheet shrink was turning out to be more than expected.

But as the article points out, the decision to reinvest the proceeds had wider ramifications. “Doing so would plunge the Fed back into the markets and might be a prelude to a future easing of monetary policy, moves that divided the men and women atop the central bank.”

According to the article, there was considerable division among the 17 members of the committee, which makes important monetary policy decisions. “At least seven of the 17 Fed officials gathered around the massive oval boardroom table, made of Honduran mahogany and granite, spoke against the proposal or expressed reservations.”

The group that favoured action expressed their concern about high unemployment and low inflation. Others were more wary, arguing that the Fed’s move would confuse investors and could convince markets that the central bank was more worried about the economy than it was. Others believed the move was premature, and the Fed should wait until the economic outlook was clearer. And some Fed officials argued that the move would likely prove ineffective. After all, companies already had access to plenty of cheap credit to fund investment, but were holding because of uncertainty.

Even though the committee ultimately voted almost unanimously in favour of reinvesting the proceeds, the WSJ article showed that the decision was clearly much more controversial than the vote suggested. This strong division among top Fed officials makes it much more difficult for Bernanke to commit to a further round of quantitative easing in tonight’s speech.

Even those who are predicting that the Fed will ultimately launch a new program to buy $1 trillion in Treasury bonds later this year concede that Bernanke’s hands are tied until there is clear evidence that the US economy is deteriorating. As a result, they say, Bernanke’s speech tonight could prove disappointing.

But others are concerned about how the market will react to a new $1 trillion round of quantitative easing. Markets may simply dismiss the policy initiative as ineffective. After all, the Fed has used the policy before without success. And while banks continue to apply stricter lending standards, and while consumers and businesses continue to fret about the economy, a further slight drop in interest rates is unlikely to produce much response.

But the fear is that a new round of quantitative easing could cause investors to lose confidence in the Fed. If investors stop believing that the US is a safe haven, and demand a higher risk premium, we could see a dangerous situation develop where US interest rates rise, while the US dollar is sold off sharply.

As a result, Bernanke will be choosing his words very carefully tonight.