Fed Optimistic Recovery Is Ahead -- but Unsure How Far and How Strong

By Neil Irwin
Washington Post Staff Writer
Thursday, September 3, 2009

Federal Reserve leaders have become more confident that the economy is stabilizing. But they are less sure about what the recovery will look like.

At an Aug. 11-12 meeting of the central bank's policymaking committee, top Fed officials agreed that improving economic data had "strengthened their confidence that the downturn in economic activity was ending," according to minutes of the meeting released Wednesday.

But that confidence did not extend to the shape of the recovery. The officials also expected the economy to improve "only slowly during the second half of this year, and all saw it as still vulnerable to adverse shocks," the minutes said.

Ample evidence in the last few months has pointed to an economy that is expanding -- producing more goods and services. But the Fed minutes show that top officials at the central bank, like their private-sector counterparts, have simmering concerns about whether the improvement will be enough to steady the job market.

"Conditions in the labor market remained poor, and business contacts indicated that firms would be quite cautious in hiring when demand for their products picks up," the minutes said.

Underscoring that continued weakness in the job market, the payroll processing firm ADP on Wednesday estimated that private firms cut 298,000 jobs in August -- more than expected. A government report Friday is also expected to show continued job losses, though less steep than a few months ago.

Also Wednesday, a Commerce Department report found that factory orders rose 1.3 percent in July, driven by a surge of orders for U.S.-made aircraft. The Labor Department said that productivity -- the amount of output produced for each hour worked -- rose 6.6 percent in the April through June quarter, more than the 6.4 percent originally estimated.

At the August meeting of the Federal Open Market Committee, officials chose to leave their target for short-term interest rates at near zero, and to keep language in an accompanying statement suggesting that rates would be left at that level "for an extended period."

They did take a first step toward unwinding the Fed's extensive interventions in the economy, indicating that an effort to buy $300 billion in Treasury bonds would be allowed to taper off by the end of October.

In following up on that action, the Fed is likely to face a tightrope in the coming months: how to start to unwind other unconventional programs that support the economy while financial markets remain fragile and the unemployment rate remains high.

The minutes gave no real hints on the Fed's thinking about that issue. "They kind of kicked the ball down the field," said John Cannally, an economist at LPL Financial in Boston.

The committee decided to wind down its Treasury bond purchases slowly "to help promote a smooth transition in markets." That could offer a hint of how the Fed will ultimately deal with its similar programs to buy mortgage-backed securities and the debt of Fannie Mae and Freddie Mac: tapering them off over time to try to avoid disrupting markets.

"I think the stretching out of the Treasury program is likely to be a model for how the Fed ends the mortgage-backed and agency-debt buying programs," said Dean Maki, chief U.S. economist at Barclays Capital.

Indeed, the Fed has particular reason to worry that ending the mortgage-purchase programs, which are scheduled to wind down by the end of the year, could pose risks to the economy. If closing the program goes poorly, mortgage rates would probably spike, potentially undoing the recent stabilization of the housing market.

"I think they're a little more concerned about that lever than others," said Paul Ballew, a senior vice president at Nationwide Insurance, referring to the mortgage-related programs. "There's still a fragile element to real estate markets, and so there will be more of a weaning process that will take some time. I suspect that is almost a weekly debate in the halls of the Fed."

Another outstanding question is how long and to what extent the Fed will continue its program to support business and consumer lending, the Term Asset-Backed Securities Loan Facility, or TALF. The minutes noted that the markets it is meant to support "showed improvement," owing in part to the program. The Fed extended the program into 2010, but has not expanded the types of lending it will support.

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