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

By Neil Irwin
Washington Post Staff Writer
Thursday, May 20, 2010; A15

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.

Also, weaker economic activity in Europe could depress the price of oil, making it cheaper for American consumers to gas up their cars or heat their homes. Already, the ripples in European markets caused the price of oil to fall to $69.87 a barrel Wednesday from almost $87 a barrel in early April.

That is exactly what happened in the East Asian financial crisis of 1997-98; the U.S. economy continued growing rapidly despite events in Asia, driven in part by a decline in oil prices.

Another way in which the crisis could help the U.S. economy is that a stronger dollar makes imports cheaper, which helps keep inflation at bay. That should give the Federal Reserve more latitude to keep interest rates extremely low for quite a while.

A goverment report Wednesday showed just how distant the inflation threat appears. The consumer price index showed that prices declined 0.1 percent in April. Over the past year, prices rose by only 0.9 percent, the smallest increase since 1966 and well below the Fed's annual inflation target of 1.5 to 2 percent.

However, the meeting's minutes also showed that the Fed is beginning to consider ways to unwind its historic economic interventions. During last month's meeting, Fed leaders discussed at length how and when to sell off some of the $2.2 trillion in assets on the central bank's books, accumulated in an extraordinary effort to prop up the economy over the past 18 months.

Some Fed officials are eager to sell some of the assets, especially mortgage-backed securities, to prevent a future burst of inflation and to keep the central bank from supporting one type of lending, mortgages, to the detriment of others. Currently, the Fed is simply letting the mortgage securities expire as they mature.

While "most participants" favored eventually selling some of the mortgage-related debt, according to the minutes, they agreed that those sales should be "communicated in advance" and "conducted at a gradual pace."

"No definitive conclusions were reached," said Peter Newland, an economist at Barclays Capital. "But there does appear to be agreement that a program of sales at some point is preferential to simply allowing the securities to run to maturity."

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