US on right track, but low rates still needed

April 16th, 2010 Leave a comment Go to comments

San Francisco Federal Reserve President Janet Yellen said her own thinking has turned the corner, and she’s now confident “the economy is on the right track,” according to remarks prepared for delivery before a meeting of Financial Executives International.

“I expect the pace of recovery to gain momentum over the course of this year and next as households and businesses regain confidence, overall financial conditions continue to improve, and lenders increase the supply of credit,” she said, in the prepared text.

“Even as we applaud the economic turnaround, it’s important not to lose sight of just how fragile this recovery is and how far we yet have to go before things return to normal.”

The Fed lowered its key short-term interest-rate target to near zero in December 2008 and pumped more than $1 trillion into the economy to stave off the worst downturn in decades. Those efforts, along with government spending, have helped the economy avert the worst, she said.

“The latest indicators show a broadening and deepening of the recovery, and point to solid, if not spectacular, expansion in the first half of this year,” she said, adding she expects the economy to grow at a pace of about 3.5 percent this year and 4.5 percent next year.

Still, she said, the unemployment rate remains at the historically high level of 9.7 percent and likely won’t dip to lower than 8.0 percent by the end of next year. That, coupled with an outlook for a decline in inflation to 1.0 percent later this year and next, means the economy is still in need of support from rock-bottom interest rates.

“Such an accommodative policy is appropriate because the economy is operating well below its potential, inflation is subdued, and such conditions are likely to continue for a while,” Yellen said. “At some point though, as the economy continues to expand, the Fed will have to pull back some of this extraordinary stimulus.”

Both businesses and consumers are increasing their spending again, although they’ll likely do so gradually, she said.

“Shoppers, after hunkering down during the recession, are clearly in a better mood,” she said. Business spending, especially in high tech, is also coming back.

But checks to growth remain. As the effects of stimulus spending begin to wane, public officials will have to start cutting spending and boost taxes in an austerity push that will slow growth, she said.

And even with very low interest rates, she said, “credit flows remain extremely weak.”

When the time does come to tighten monetary policy, the Fed will not need to trim its swollen balance sheet before it can effectively do so, she said.

Rather, she said, the central bank can raise the interest it pays on reserves to boost all short-term rates. Trimming the balance sheet will come later, she suggested, and will be gradual and deliberate.

“We’ve emerged from the worst financial and economic crisis most of us have ever seen,” she said. “That should give us confidence that we can move forward, put more Americans to work, keep inflation in check, and return to the economic vibrancy that our nation is known for.”

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