Thursday, June 24, 2010

Fed Grows More Wary on Economy

By JON HILSENRATH

The Federal Reserve offered a subdued assessment of the U.S. economy Wednesday and affirmed that short-term interest rates would remain near zero for "an extended period," which most economists now believe could mean well into 2011 and possibly into 2012.



."Financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad," namely in Europe, the central bank said after a two-day policy meeting.



Market expectations for when the Fed will raise interest rates have already shifted notably in the past two months, amid economic turmoil in Europe and signs that the U.S. economy hasn't built much momentum after turning around in mid-2009.



.The Fed on Wednesday said the recovery from the deep recession is "proceeding," a departure from its April assessment that the recovery "continued to strengthen." Consumer spending is "increasing but remains constrained," the job market is improving "gradually," housing is "depressed" and inflation—already low—has "trended lower," the central bank said.



The federal-funds interest rate—a Fed-influenced rate at which banks lend to each other overnight—has been between zero and 0.25% for 18 months. Economists, on average, expect the Fed to keep it there until March 2011, according to a survey conducted by The Wall Street Journal this week.



In the past three weeks, 15 of 44 economists surveyed regularly said they have delayed their predictions for when the Fed will raise rates to a later date. As recently as April, the bulk of the forecasters expected such a move before the end of 2010; now a few say it won't happen until 2012.



Global Rate Tracker

View Interactive

..The Fed's statement did little to dissuade economists from their latest views. "We're looking at this as a very slight downgrade of their business-conditions assessment," said Maury Harris, chief U.S. economist for UBS Securities, which pushed its forecast of a rate increase to January 2011; two weeks ago, it predicted September 2010.



"High unemployment and low inflation will keep the Fed sidelined," said Bruce Kasman, J.P. Morgan Chase's chief economist. He moved his forecast to November 2011 from April 2011.



Most central-bank officials are in wait-and-see mode, trying to preserve their flexibility to raise interest rates soon if employment grows briskly and financial markets settle down, or to hold off further if joblessness proves stubborn or the economic outlook deteriorates. At some point after raising rates, Fed officials also are inclined to gradually sell the bank's massive holdings of mortgage-backed securities, acquired over the past year-and-a-half to pull down mortgage rates.



.Speedy action looks increasingly unlikely. Several officials said before this week's meeting that financial turmoil in Europe could dent U.S. growth, and they reaffirmed that worry with their latest reference to developments abroad. Persistently high numbers of Americans seeking unemployment insurance are another concern. Some officials went into this week's meeting wanting to discuss how the Fed would respond if the economy unexpectedly underperforms expectations. Minutes with details of the discussions will be released in three weeks.In a new sign of the economy's fragility, the Commerce Department reported Wednesday that sales of new homes fell 32.7% in May as a tax credit for home purchases expired



Some at the Fed still want to raise rates soon. Thomas Hoenig, president of Kansas City Federal Reserve, dissented from the central bank's decision for the fourth time this year, arguing that its assurance of low rates for a long time wasn't now warranted.



There are risks to the Fed's strategy. In the early 2000s, it kept short-term interest rates at 1% for a year, a move critics say spurred the housing bubble and excessive borrowing. "If I were Ben Bernanke, I would start preparing people, especially as Europe cools down, that interest rates are going to move to more normal, but still low levels," said Raghuram Rajan, a professor at the University of Chicago Booth School of Business.





Ben Bernanke

.But Fed officials see few signs that either inflation or asset bubbles are brewing, and thus don't feel great pressure to act. Inflation is running below the Fed's target. There had been some internal debate at the Fed earlier in the year about whether the inflation slowdown was broad-based or concentrated in housing. That debate is now largely settled.



"Prices of energy and other commodities have declined somewhat in recent months," the Fed said Wednesday, adding, "underlying inflation has trended lower."



And banks, rather than spurring a bubble with money the Fed has pumped into the economy, have continued to rein in lending. Since January, bank holdings of Treasury bonds have risen 3%, while their commercial and industrial loan portfolios have fallen by 4% and real-estate loans have contracted by 2%.



Write to Jon Hilsenrath at jon.hilsenrath@wsj.com