Fed meets as economy flashes signs of strength; will likely discuss how to reverse rate course

Fed meets as economy shows signs of strengthening

WASHINGTON — With signs the economy is strengthening, Federal Reserve policymakers are increasingly focused on when and how they will start boosting rates once the recovery is firmly entrenched.

Higher rates for millions of American borrowers are still months away at best, most economists predict.

Yet, Fed Chairman Ben Bernanke and his colleagues, who opened a two-day meeting Tuesday afternoon, are likely to discuss how best to use the various tools at their disposal to tighten credit and mop up the unprecedented amount of money that was pumped out to fight the economic and financial crises.

The Fed meets as the economy flashes growing signs of improvement.

Employers are creating jobs. Americans’ confidence is rising and they are spending more. Manufacturers are boosting production. And, an increasing number of companies — such as Ford, UPS and Caterpillar — are seeing their profits grow. By those measures, the economy is in better shape now than when the Fed last met in mid-March.

Still, there are continuing strains: high unemployment at 9.7 percent, loans are hard for people and businesses to obtain, and the housing and commercial real-estate markets are fragile. Greece’s debt crisis also is roiling Wall Street. Stocks plunged 213.04 points to close at 10,991.99.

“The Fed is going to sound more upbeat about the economy. Its message: the recovery is intact, but it is not so strong yet that it feels the need to signal tighter policy,” said Mike Feroli, economist at JP Morgan Chase Bank.

Still, the Fed won’t be able to wait for all the economy’s current problems to disappear before it switches course. The timing and execution of a Fed policy shift is a high-stakes game.

The Fed needs to hold rates at record lows long enough to make sure the recovery is lasting, especially once the bracing effects of the government’s massive fiscal stimulus fades later this year.

On the other hand, the Fed must be nimble to start tightening credit to prevent inflation from becoming a problem or sowing the seeds of new speculative excesses such as in the prices of stocks, bonds or commodities.

One tricky question is when the Fed should start selling some of its vast portfolio of mortgage securities. The Fed bought $1.25 trillion of these securities to drive down mortgage rates and aid the housing market. Its challenge is to sell those assets in a way that doesn’t weaken home prices and push up mortgage rates.

“My expectation is that sales would be slow, gradual, announced in advance, and would not create undue market impacts,” Fed Chairman Ben Bernanke told Congress recently.

The Fed’s balance sheet has exploded, reflecting the central bank’s action to fight the financial crisis. It stood at $2.3 trillion for the recent week, more than double the level before the crisis struck.

“I think we would like to bring the balance sheet back to something consistent with where it was before the crisis,” Bernanke told lawmakers. “And that would suggest something under a trillion dollars, I think, would be appropriate.”

Besides selling securities outright, the Fed has a number of other tools to shrink its balance sheet when it moves to tighten credit. Those include selling securities from its portfolio with an agreement to buy them back later. Those operations are called reverse repurchase agreements. The Fed also is moving forward on a plan to let banks to set up the equivalent of certificates of deposit at the central bank. That would give banks an incentive to park money at the Fed, rather than lending it out.

For now, Bernanke and other Fed officials have repeatedly signaled that they will need to hold rates at record lows for some time to come to foster the fledging recovery.

When the Fed wraps up its meeting on Wednesday, policymakers are all but certain to leave their key bank lending rate between zero and 0.25 percent, where it’s remained since December 2008.

Assuming the Fed leaves rates alone, commercial banks’ prime lending rate, used to peg rates on certain credit cards and consumer loans, will stay about 3.25 percent. That’s its lowest point in decades.

Rock-bottom rates serve borrowers who qualify for loans and are willing to take on more debt. But they hurt savers. Low rates are especially hard on people living on fixed incomes who are earning scant returns on their savings.

Still, if super-low rates spur Americans to spend more, they will help invigorate the economy. That’s why the Fed also is expected to repeat its pledge — in place for more than a year — to keep rates at record lows for an “extended period.”

Some concern has emerged inside the Fed that that pledge could limit its ability to quickly raise rates when necessary. Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, for two straight meetings has opposed the Fed’s decision to retain the “extended period” pledge.

Hoenig said he fears keeping rates too low for too long could lead to excessive risk-taking by investors, feeding new speculative bubbles. He’s also expressed concern that low rates could eventually unleash inflation.

Yet Bernanke and other Fed officials in recent weeks have made clear that the Fed’s pledge to keep rates at record lows for an “extended period” is linked to the economy’s performance — not to a specific period. The Fed will raise rates whenever it decides it’s necessary, Bernanke has said.