Fed May Raise U.S. Economic Assessment, Affirm Near-Zero Rates

By Steve Matthews and Vivien Lou Chen

Dec. 16 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke and his colleagues may indicate the U.S. recovery is gaining strength while repeating a pledge to keep the benchmark interest rate almost at zero for an “extended period.”

The Federal Open Market Committee gathers as growth in the final quarter of 2009 accelerates to more than 4 percent, the fastest pace in almost four years, according to analysts’ forecasts. The FOMC will probably discuss how to eventually withdraw unprecedented programs to revive credit, including purchases of $1.43 trillion in housing debt, economists said.

Fed officials in a statement today may try to head off any investor expectations the improving economy will prompt them to raise interest rates early next year. While acknowledging that job losses are easing after last month’s drop in the unemployment rate, the FOMC may reaffirm that tight credit and weak income growth are among the risks to the recovery.

“The last thing they want is for people to expect that tightening is closer,” said Laurence Meyer, vice chairman of Macroeconomic Advisers LLC in Washington and a former Fed governor. “They are going to increase their confidence about the sustainability of the expansion, but not become materially more optimistic about growth next year.”

The FOMC is scheduled to issue its statement at around 2:15 p.m. after the end of its two-day meeting.

“Assuming they don’t drop ‘extended period,’ market reaction will probably be limited,” said James O’Sullivan, chief economist at MF Global Ltd. in New York.

Changed Forecasts

Macroeconomic Advisers raised its forecast for fourth- quarter growth last week to a 4.2 percent annual pace from 3.1 percent, while Credit Suisse and JPMorgan Chase & Co. increased its estimate by 1 percentage point to 4.5 percent. Retail sales in November climbed twice as much as economists expected, while exports rose to the highest level in 11 months, government figures showed.

“The Fed has to fight two battles: supporting economic growth and showing the market it is concerned about potential inflation later on,” said Sung Won Sohn, former chief economist at Wells Fargo & Co. and now an economics professor at California State University-Channel Islands in Camarillo, California. “Balancing inflation and economic growth and the communications related to that will be their most difficult challenge.”

Fed funds futures on the Chicago Board of Trade indicated yesterday a 53 percent chance that the FOMC will raise its main lending rate by at least a quarter-percentage point by its June meeting, compared with 35 percent odds a month ago.

Fulfill Mandate

Any expectation by investors that monetary policy tightening will occur sooner would complicate efforts by policy makers to reduce the 10 percent unemployment rate, said former Atlanta Fed research director Robert Eisenbeis, now chief monetary economist at Cumberland Advisors Inc. in Vineland, New Jersey.

“They have a huge problem, and the risk is real,” he said. “It will take extraordinary growth for three years to significantly eat into the unemployed who have lost their jobs.”

U.S. payrolls have fallen by 7.2 million since the start of the recession in December 2007, and a growing population means more jobs must be created to restore full employment. The FOMC projects the unemployment rate will be between 9.3 percent and 9.7 percent in the fourth quarter of 2010, according to forecasts released after its November meeting.

Policy makers will probably also continue to debate the usefulness of selling assets as part of the so-called exit strategy from the unprecedented expansion of credit, Fed watchers said. Central bank officials have tested the use of reverse repurchase agreements to drain some of the cash the Fed has pumped into the economy.

Main Lending Rate

The Fed has kept the benchmark lending rate at a range from zero to 0.25 percent during the past 12 months and has adopted asset purchases as its main policy tool. Since March, the FOMC has said “exceptionally low” rates are likely warranted for “an extended period.”

Bernanke and New York Fed President William Dudley, who serves as vice chairman of the FOMC, signaled in speeches last week that they favored keeping the language.

The U.S. economy faces “formidable headwinds,” including a weak labor market and tight credit, that will probably generate a “moderate” pace of expansion, Bernanke said.

Growth will probably decline next year from the 3 percent to 3.5 percent pace likely in the last six months of this year, “mostly because some of the current sources of strength are temporary,” Dudley said.

‘Pretty Fragile’

“The economy is still pretty fragile,” said Dean Croushore, a former Philadelphia Fed economist who is now chair of the economics department at the University of Richmond in Virginia. “Because inflation has remained low and growth is positive, but not overly strong, the Fed has time to think about how to reduce the excess amount of liquidity in the market.”

The central bank will probably continue to describe inflation as “subdued” and inflation expectations as “stable,” economists said. The Fed’s preferred price measure, which excludes food and fuel, climbed 1.4 percent in October from a year earlier.

To contact the reporters on this story: Steve Matthews in Atlanta at smatthews@bloomberg.net; Vivien Lou Chen in San Francisco at vchen1@bloomberg.net