Fed to mull recovery, financial stability at policy meeting

WASHINGTON Tue Nov 3, 2009 7:29am EST

A man walks in front of the U.S. Federal Reserve building in Washington, June 24, 2009. REUTERS/Jim Young

A man walks in front of the U.S. Federal Reserve building in Washington, June 24, 2009.

Credit: Reuters/Jim Young

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WASHINGTON (Reuters) - Federal Reserve officials meeting this week must weigh improving economic data against the risk, reinforced by a persistently weak job market, that a burgeoning recovery remains on shaky ground.

A 3.5 percent annualized jump in third quarter gross domestic product revived debate between analysts who believe a sustainable turnaround is under way, and those who think growth will falter once a heavy dose of stimulus fades.

The uncertainty is evident within the Fed itself, with many policymakers emphasizing the hazards in their outlook, even as they vow to vigorously fight any early signs of inflation.

With inflationary warning signals largely absent, an immediate shift in the central bank's ultra-easy policy stance, including any tinkering with its pledge to keep interest rates low for an "extended period," appears unlikely.

"The Federal Reserve is unlikely to change its assessment significantly," said Marc Chandler, global currency strategist at Brown Brothers Harriman.

The Federal Open Market Committee, the central bank's policy setting group, meets on November 3 and November 4.

RECOVERY'S ARRIVAL

The third quarter GDP report on Friday signaled the end of the worst U.S. recession since the Great Depression, but government stimulus, including the "cash for clunkers" incentive for auto purchases and a $8,000 tax credit for first time homebuyers, helped prop the economy up.

The Institute for Supply Management's manufacturing index, a widely watched barometer of industrial strength, suggested activity remained robust in October. The measure jumped to 55.7 last month, its highest level since April 2006. It has held above the 50 line that separates expansion from contraction for three straight months.

Even the ISM employment index, long in contraction territory, turned positive, indicating the first inklings of a willingness to hire.

"Given the fairly good performance of this indicator in predicting the performance of the U.S. economy more generally, it is pointing to further upward momentum in U.S. economic activity," said Millan Mulraine, economics strategist at TD Securities.

THE UNEMPLOYMENT PROBLEM

Despite signs factory activity is picking up, the U.S. consumers who normally account for around 70 percent of the economy's growth, are facing major challenges.

Chief among them is a jobless rate currently hovering at a 26-year high just below 10 percent, which is expected to continue climbing into next year.

Coupled with three years of declines in home values, the unfavorable labor market has dampened consumers' appetite to spend. Even for those who have managed to hold onto their jobs, incomes largely remain stagnant or have lost ground.

The grim employment outlook raises doubts about whether growth can be sustained when the effects of the government's stimulus program fade.

FINANCIAL STABILITY

The banking sector, which has regained some of its swagger but remains relatively fragile, is another important consideration for Fed officials.

Some banks, like JPMorgan and Goldmans Sachs, have returned solidly to profitability and have, controversially, set aside vast sums for bonus payouts.

But much of this largess, say analysts, is the product of the government's implicit -- and sometimes explicit -- backing. The perception, cemented after Lehman Brothers' disastrous bankruptcy, that the public sector will not allow a major financial institution to fail, has lowered the cost of borrowing for banks.

Losses in the commercial real estate sector, which have been flagged loudly by Fed Governor Daniel Tarullo and a host of regional central bank presidents, suggest the perils of the credit crunch are not yet over for banks.

This should make the Fed leery of any sudden policy movements that might unhinge gains made thus far.

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