Fed expects GDP to expand, unemployment rate to fall this year

By Neil Irwin
Washington Post Staff Writer
Thursday, May 20, 2010

Just as a deepening debt crisis in Europe threatens the world economy, the U.S. recovery is finally starting to gain traction, leading Federal Reserve officials and private analysts to upgrade their expectations for growth.

The Fed's leaders now expect gross domestic product to expand to 3.2 to 3.7 percent this year, according to a forecast released Wednesday by the central bank, up from 2.8 to 3.5 percent projected in January. They also expect the unemployment rate to fall to the 9.1 to 9.5 percent range by the end of the year. The rate was 9.9 percent in April.

The revised forecast highlights the gathering strength of the recovery, which was slow and fragile when it began nearly a year ago. The nation added jobs in five of the past six months, including 290,000 in April. Retail sales have risen as consumers gain confidence to make major purchases. Production in the industrial sector is rising rapidly.

But Fed leaders and private economists also see an emerging risk from the European debt crisis, which is causing a new wave of panic in world financial markets and could create new challenges for exporters in the United States.

At the Fed's policy meeting in late April, some officials were concerned that the crisis "could have an adverse effect on U.S. financial markets, which could also slow the recovery in this country," according to meeting minutes released Wednesday.

Momentum 'looks good'

Since that meeting, conditions in Europe have worsened dramatically. The stock market in Europe fell another 2.9 percent Wednesday, and is now down 11 percent over the past four weeks. Bank lending rates are up, despite a massive bailout program announced May 9.

"The momentum behind the domestic economy looks good," said David Wyss, chief economist at Standard & Poor's. "It's a stronger recovery than we expected to see at this point. But at the same time you have serious financial issues in Europe that are affecting global financial markets and have the potential to undermine the recovery."

Even if the European crisis continues to deepen, its impact on the U.S. economy remains hard to predict. The biggest risk is the spread of fear in financial markets. A key driver of the U.S. turnaround has been a virtuous cycle in which rising confidence has led to a rising stock market and greater availability of credit, which in turn has helped improve business and consumer confidence.

One way that Europe's problems could hurt the United States would be by slowing U.S. exports. As the European crisis has intensified, investors have shifted more of their money into dollars, driving up the value of the dollar relative to the euro.

A stronger dollar makes U.S. goods less competitive in Europe, which accounts for about a quarter of all U.S. exports. It could also hurt American exports to many other nations, such as China, that peg their currencies to the dollar.

Europe could help U.S.

However, the crisis across the Atlantic could also help the U.S. economy. Because investors view the United States as a safer place to park their money, they are buying Treasury bonds in droves, driving down the rate the U.S. government must pay to borrow.

Interest rates on 10-year government bonds have fallen from almost 4 percent in early April to 3.4 percent Wednesday. Those lower rates are helping to stimulate the economy by reducing mortgage rates for U.S. home buyers and cutting companies' borrowing costs.

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