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Aware of policy risks, Fed sees firmer U.S. growth

By Pedro da Costa and Mark Felsenthal

WASHINGTON (Reuters) - Federal Reserve officials are increasingly confident the U.S. economic recovery will be durable, but do not see employment or inflation picking up soon, minutes from their November meeting showed.

Senior Fed officials, meeting on November 3-4, also expressed concern their plans to keep interest rates low for a prolonged period could have negative repercussions, including possible speculative activity in financial markets.

"Most participants now view the risks to their growth forecasts as being roughly balanced rather than tilted to the downside," according to the minutes, which were released on Tuesday and were accompanied by upward revisions to policy makers' growth forecasts.

"Some negative side effects might result from the maintenance of very low short-term interest rates, including the possibility that such a policy stance could lead to excessive risk-taking in financial markets or an unanchoring of inflation expectations," they said.

The comments helped U.S. stocks to pare losses.

The Fed cut benchmark interest rates to near zero percent last December and has pumped more than $1 trillion into the economy to beat back a severe recession and restore growth.

After their meeting earlier this month, policy makers repeated a pledge to keep rates exceptionally low for "an extended period."

Many observers, including influential investors and some officials, have argued that the Fed's policy of rock-bottom borrowing costs may be driving investors to lever up their bets by using the falling U.S. dollar to fund their trades.

President Barack Obama, during a recent visit to Asia, was lectured on the subject by top government officials in China.

The Federal Open Market Committee, the U.S. central bank's policy-setting body, said it did not believe such speculative activity had taken place to date, saying the dollar's decline had thus far been "orderly."

"Any tendency for dollar depreciation to intensify or to put significant upward pressure on inflation would bear close watching," the minutes said. The U.S. currency dropped to a 15-month low against a basket of major currencies last week.

Fed Chairman Ben Bernanke devoted an unusually long portion of a speech delivered in New York last week to discussion of the dollar, saying he was keeping an eye on its movements but suggesting it was not an overwhelming influence on policy for now.

NO INFLATION HERE

The minutes indicated policy makers are not widely concerned about inflation in the medium term.

That stance has been evident in a string of recent speeches, in which even the normally hawkish presidents of the Dallas and Philadelphia Federal Reserve banks showed little concern over the prospects for a sustained rise in consumer prices.

The "central tendency" forecasts of policy makers appeared slightly more sanguine on the economy's prospects. U.S. gross domestic product was expected to shrink substantially less this year, somewhere in a range of -0.4 percent and -0.1 percent. The Fed had previously expected a contraction between 1.5 percent and 1 percent.

Similarly, the jobless rate, currently at a 26-1/2 year high of 10.2 percent, was seen easing more quickly than policy makers had believed back in June.

Nonetheless, there was a sense that any turnaround in the labor market would not be fast enough to stem the rising tide of joblessness. Estimates from FOMC members foresaw uncomfortably high unemployment of as much as 7.5 percent by the end of 2012.

"The weakness in labor market conditions remained an important concern," the minutes said. "The considerable decelerations in wages and unit labor costs this year were cited as factors putting downward pressure on inflation."

Core inflation, which excludes volatile food and energy costs, was seen well within the Fed's presumed ceiling of 2 percent through 2012, suggesting increases in interest rates are a way off.

Still, some officials worried a recent spike in commodity prices, which some analysts say is a byproduct of the Fed's emergency liquidity measures, could hold the seeds of future inflation.

In addition to slashing interest rates sharply as the global financial crisis gathered pace last year, the Fed also instituted a number of special lending programs to keep the financial system afloat.

TIMING IS EVERYTHING

Despite a general agreement on the prospects for a weak but enduring economic rebound, the minutes showed Fed officials had not yet reached consensus on how best to orchestrate an exit from their emergency policy measures.

Some favored selling some of the assets the Fed has accumulated back into the markets.

It has bought $300 billion in longer-term U.S. government debt and is on its way to purchasing more than $1.4 trillion of mortgage-related securities as a way to drive down borrowing costs with overnight rates already near zero.

Others thought asset sales would be disruptive, believing instead that the Fed should first employ other tools, like reverse repurchases agreements and the payment of interest on bank reserves, to draw money out of the financial system.

"Such sales might elicit sharp increases in longer-term interest rates that could undermine attainment of the committee's goals," some members said.

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