Fed Unconvinced Economy’s ‘Stabilization’ to Persist

By Scott Lanman and Steve Matthews

May 21 (Bloomberg) -- Federal Reserve officials, who see possible signs of “stabilization” in the U.S. economy, signaled they’re not convinced those improvements will persist.

Policy makers, meeting April 28-29 in Washington, saw “significant downside risks” to the outlook for the economy, with the global financial system still “vulnerable to further shocks,” minutes of the session released yesterday said.

The report indicates that Fed officials may be ready to build on their plan in March to buy $300 billion of Treasuries should the economy or financial markets deteriorate further. Some policy makers said an increase “might well be warranted at some point to spur a more rapid pace of recovery” from the worst recession in five decades, the minutes showed.

“They are talking about keeping an option open in case things get worse for some reason,” said John Silvia, chief economist at Wachovia Corp. in Charlotte, North Carolina, who previously worked as a senior economist in Congress. “But if the economy improves, they don’t need to do any more.”

Government-bonds rallied after the report, indicating some investors expect the Fed to make additional purchases. Yields on benchmark 10-year notes dipped 5 basis points to 3.19 percent by the close; they were at 3.17 percent at 7:40 a.m. in New York. Futures on the Standard & Poor’s 500 Stock Index were down 0.6 percent at 894.80.

New Forecasts

Yesterday’s minutes also updated economic projections from the 17 Fed policy makers, who forecast a deeper U.S. contraction than they foresaw in January, with a 9 percent unemployment rate lasting through the end of 2010.

Central bankers made their biggest cut yet to next year’s growth forecast, indicating the economy won’t rebound as quickly as previously anticipated. The jobless rate may remain as high as 8.5 percent in late 2011. The weaker forecasts are in line with changes to projections by private economists over the past few months.

“Participants generally expected that strains in credit markets and in the banking system would ebb slowly, and hence the pace of recovery would continue to be damped in 2010,” the Fed said in the minutes. Economic growth will pick up in 2011 as financial conditions improve, the Fed said.

Rate Level

U.S. central bankers cited a slower pace of contraction in their April statement, leaving the benchmark interest rate trading in a range of zero to 0.25 percent. They cited improved financial conditions, stronger sentiment from businesses and households and expectations of an increase in industrial production to replace inventories.

“Improvement in business activity is not far off,” Minneapolis Fed President Gary Stern said May 19 in a speech. “Interest rates are low and financial conditions are improving,” he said. “The improvement is gradually becoming more broadly based.”

A firming in consumer confidence, industrial production and other areas of the economy indicate the recession may be easing. Output at factories, mines and utilities decreased 0.5 percent last month after dropping 1.7 percent in March, Fed figures showed last week.

That doesn’t necessarily mean policy makers are counting on continued improvement, yesterday’s report indicated.

“As a group, they are still nervous about where we are,” said William Ford, a former Atlanta Fed chief who’s now at Middle Tennessee State University in Murfreesboro. “There are a number who are still pessimistic about the outlook. Even though there is talk of green shoots, they want to see more evidence of a turnaround.”

Economic Contraction

The economy is contracting at a 1.1 percent annual pace in the second quarter, according to estimates from Macroeconomic Advisers LLC, compared with a 6.1 percent annual rate of decline in the first three months of the year.

The Fed has expanded assets on its balance sheet by $1.3 trillion over the past year to $2.2 trillion to replenish liquidity, narrow credit spreads and support borrowing and spending.

“Participants continued to see significant downside risks to the economic outlook,” the minutes said. “While financial strains and risk spreads had lessened somewhat over the intermeeting period, participants agreed that the global financial system remained vulnerable to further shocks.”

Commercial Property

The central bank said May 19 that in July it will begin accepting commercial mortgage-backed securities issued before Jan. 1 into the Term Asset-Backed Securities Loan Facility, which provides financing to investors in asset-backed securities backed by consumer and business loans.

The Fed’s securities purchase program hasn’t prevented yields on U.S. notes from rising. Ten-year Treasury yields are up from 2.53 percent March 18 when the central bank said it would buy $300 billion of government debt over six months.

Banks are still struggling with rising loan delinquencies in a variety of categories. Nearly 8 percent of residential real estate loans were delinquent in the first quarter, up from 6.3 percent in the fourth quarter, according to seasonally adjusted Fed data.

“Meeting participants noted that the volume of credit extended to households and businesses was still contracting as a result of shrinking demand, declining credit quality, capital constraints on financial institutions, and the limited availability of financing through securitization markets,” the minutes said.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net; Steve Matthews in Atlanta at smatthews@bloomberg.net.