I have been dealing with this issue and this is how I have dealt with it.
Step One Get the path and file name of your graphics in the right format:
First I have a naming convention and a specific location for my jpeg files. I store the picture file name and location in my query and base the file name on a unique ID. For my purposes I use c:\pictures for storing my photos, however, when including a path you must use double slashes, not single, ie "c:\\picture\\filename.jpg"
Pass this field to your merge document instead of the object.
Step two set your merge document up to accept the filename into a field:
In your merge document chose Insert | Field and select Links/References then INCLUDEPICTURE then finish the command as follows
[INCLUDEPICTURE " " \c jpegim32]leave off the brackets
Click OK. This should give you a blank object. Click on it and press shift F9. This will reveal the code for this field. Insert the merge field with your file location between the double quotes.
When you do your mail merge this will send all the information you need to display the photo. The only drawback is you have to update the link to this object. Goto Edit | Links Update now.
As I said I have been working with this issue and this is as far as I have gotten.
I am still trying to find a better way to get the file name of the object. I would like to directly access the file name from the object itself, but have not figured that out yet.
Also, I am trying to get the merged document to automatically update the object, but have not figured that out either.
I hope this helps. If you have any thoughts about these other issues I would appreciate the input. Please let me know if this works for you.