Fed officials see U.S. rebound starting in second half

CEDAR RAPIDS, Iowa (Reuters) - Two top Federal Reserve officials on Wednesday expressed confidence that despite continuing unending bleak news on the U.S. economy, a recovery could start to take shape in the second half of 2009 if financial markets and the housing sector gain a foothold.

Gary Stern, president of the Minneapolis Federal Reserve Bank, and Charles Plosser, president of the Philadelphia Fed, in separate remarks forecast a slow recovery that would gather momentum next year. Their outlooks came as the Fed's Beige Book report on regional economic conditions showed a notably gloomy scene at the end of 2008 and into the new year.

But Plosser, known as a policy hawk on inflation, gave a graver assessment of the inflationary threat posed in the longer term from the Fed's current unorthodox policy measures centered around pumping massive amounts of liquidity into financial markets.

The government's aggressive economic policy responses, including those planned by the incoming Barack Obama administration, should ultimately turn the economy around, Stern said in a speech to local business leaders in Cedar Rapids, Iowa.

But even with a major fiscal stimulus package on tap to boost overall demand, the early stages of recovery are likely to be subdued, with "healthy growth" unlikely before the middle of 2010, Stern said.

"In view of the state of the credit markets and of the housing sector, it seems a fair bet that it will take time for momentum to build," he said. "The economy is in the midst of a serious recession that seems likely to persist for at least another two quarters."

Plosser gave a similar view, saying he sees "the economy starting to slowly recover in the second of 2009 and building up momentum in 2010" and sees the housing market hitting bottom this year.

The suggestion by Stern and Plosser that the U.S. could break out of recession, even with a tentative recovery, in the second half was at odds with growing sentiment that the downturn, already more than a year old, could linger into 2010.

Earlier this month, economist Martin Feldstein, former head of the National Bureau of Economic Research, said the nation would be "lucky" to see recession end this year.

INFLATION OR DEFLATION?

Stern downplayed the threat of deflation from the decline in U.S. economic growth and an outbreak of inflation fueled by a massive expansion to the Fed's balance sheet.

December consumer inflation figures due on Friday are likely to show a year-on-year decline in consumer prices, sparking fears that deflation, or a damaging downward spiral in prices, could be setting up as economic growth stalls.

Stern said neither deflation or inflation could be "dismissed out of hand," but said that "if economic growth resumes in the United States as I expect, the threat of deflation should diminish commensurately."

To support the crisis-stricken credit markets, the Fed has more than doubled its balance sheet to over $2 trillion through measures like buying troubled assets.

Stern said there was "ample time to withdraw excess liquidity as appropriate," and the Fed "remains firmly committed to long-run price stability."

By contrast, Plosser urged the development of a clear exit strategy and said he would prefer the Fed's balance sheet to be "a little more pristine."

"Our aggressive lending, while intended to help the economy and financial crisis recover, poses its own set of challenges," Plosser said at a conference at the University of Delaware in Newark. "We must develop a well-articulated exit strategy if we are to maintain control of monetary policy and encourage the revival of strong and disciplined credit markets."

He forecast that the Fed will face challenges when it attempts to liquidate the longer-term assets from its portfolio. "Will there be pressure to extend some of these programs by observers who feel terminating the programs might disrupt fragile markets?" Plosser asked, warning that such pressures could threaten the Federal Reserve's independence.

Stern and Plosser are both non-voters on the policy-setting Federal Open Market Committee in 2009, but voted in 2008 as the FOMC cut interest rates essentially to zero and kicked off a type of "quantitative easing" to support the U.S. economy once its main policy tool had been neutralized.

BEIGE BOOK LOOKS BLUE

In the Beige Book report, which is published eight times a year based on information gleaned from the 12 Fed districts, the central bank said retail sales were generally weak during the just-ended holiday season despite deep discounting.

The Fed also said that lending activity declined or stayed weak in many areas, and credit conditions were tight or getting tighter while commercial real estate markets deteriorated.

Against that backdrop, various Fed districts reported more workers losing jobs, hiring freezes, and reduced hours for some employees. The New York district reported that "substantial" job reductions have yet to show up in payrolls data.

(Additional reporting by Kristina Cooke in Newark, Del., Editing by Leslie Adler)