Fed to take slow road back to normal interest rates

The Federal Reserve is likely to wait to ensure a sustainable economic recovery is underway before lifting interest rates from the current level near zero, analysts say.

The Federal Open Market Committee concludes a two-day policy meeting Wednesday widely expected to hold unchanged its key federal funds rate at a record low range of zero to 0.25 percent to spur lending and economic activity.

Markets will be watching the FOMC's statement accompanying its decision Wednesday for clues about the momentum of the world's largest economy, which seems to be emerging from the worst slump since the Great Depression.

"The economy is clearly moving into recovery, but that recovery is still extremely fragile," said Diane Swonk, chief economist at Mesirow Financial.

"This means that the Fed will remain vigilant in its support of credit markets and will keep rates close to zero well through the spring of next year."

Others agree that the Fed, led by chairman Ben Bernanke, will maintain a stimulative policy.

"The odds are high the Fed will err on the side of caution and boost rates later than it should," said Kent Engelke, chief economic strategist at Capitol Securities Management.

"Bernanke is the premier student of the Depression. To refresh all, the Federal Reserve increased interest rates prematurely in 1931, action many historians believe is a reason why the economy turned even lower. I doubt Bernanke will risk repeating the same mistake."

Ian Shepherdson at High Frequency Economics said he would be "astonished" to see any shift in the Fed's core position, "namely that the economy will remain weak for an extended period, inflation will be subdued for the foreseeable future and policy remains on hold."

The markets will focus on whether the Fed will adjust its unprecedented efforts to pump over one trillion dollars of liquidity into the stricken financial system, which some call "quantitative easing."

"The Fed and chairman Ben Bernanke have made it very clear that they will stay the course, which means don't expect any changes in policy or wording," said Joseph Balestrino, strategist at Federated Investors.

"If anything, the Fed may acknowledge recent economic 'improvements,' but we don't expect it to signal any change this year in the target federal funds rate ... Nor do we anticipate any change in its quantitative easing measures, which have worked to bring stability and liquidity to the debt markets."

The upbeat US economic outlook gained support from better-than-expected recent government readings on growth and unemployment.

Gross domestic product (GDP) -- the broad measure of the economy's activity -- fell at an annualized rate of 1.0 percent in the second quarter, after a 6.4 percent plunge in the January-March period.

Unemployment dipped unexpectedly in July to 9.4 percent, one-tenth point lower than the 26-year high hit in June. Although job losses narrowed to 247,000 from 443,000 in June, the labor market remained frail. A total of 6.7 million jobs have vanished from payroll since the recession began in December 2007.

A monthly survey of more than 50 business economists supported the view of growing optimism about prospects for economic growth in the second half of this year and in 2010.

Blue Chip Economic Indicators report predicted GDP would grow at an annual rate of 2.2 percent in the current quarter and 2.3 percent in the fourth quarter.

Many analysts say the Fed needs to signal that it has an exit strategy in place to end the easy money policy when recovery is in place to prevent runaway inflation.

The US Federal Reserve building in Washington

Cary Leahey, economist at Decision Economics, said the Fed normally will want to see improvement in the labor market before boosting rates.

"Historically the unmeployment rate has had to decline two-tenths of a point for the Fed to tighten," he said.

"But they could tighten quickly after that. The market is not unreasonably suggesting a move in February or March of next year."

source AFP

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