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Pianalto Says ‘Exceptionally Low’ Rates Are Warranted

May 18 (Bloomberg) -- Federal Reserve Bank of Cleveland President Sandra Pianalto said the U.S. economy is recovering gradually from the recession and reiterated the central bank’s pledge to keep interest rates “exceptionally low” for an “extended period.”

“Our journey out of this deep recession will be a slow one because we face two primary headwinds that I expect will temper growth for a while,” Pianalto said in a speech today in Pittsburgh. “The first is the effect of prolonged unemployment, and the second is a heightened sense of caution on the part of consumers and businesspeople.”

The Fed is waiting for evidence the economy is improving before raising the benchmark interest rate from a record low. Policy makers said on April 28 after a two-day meeting that the economy has strengthened, while noting that a rise in household spending is impeded by obstacles including tight credit and high unemployment.

Treasuries rose today after an unexpected decline in producer prices reinforced expectations the Fed will keep interest rates low. The yield on the 10-year note fell 10 basis points to 3.39 percent at 2:31 p.m. in New York.

The 0.1 percent decline in prices paid to factories, farmers and other producers followed a 0.7 percent increase in March, the Labor Department said today. Excluding food and fuel, so-called core prices climbed 0.2 percent, compared with 0.1 percent gains in the previous two months.

Labor Market

Pianalto said the weak labor market and consumer caution are tempering her inflation forecast. The economy added 290,000 jobs in April, while the unemployment rate unexpectedly rose to 9.9 percent as people reentered the labor force seeking work, the Labor Department said on May 7.

Underscoring Pianalto’s outlook, Wal-Mart Stores Inc., the world’s largest retailer, said today that a 10 percent increase in first-quarter profit was driven by growth in Mexico, Canada and China that helped make up for sales declines at U.S. stores.

“A number of economic pressures, including gas prices and ongoing concerns about unemployment, continue to affect key segments of retail, and this is especially true for Wal-Mart’s core customer,” Mike Duke, chief executive officer of Bentonville, Arkansas-based Wal-Mart, said on a conference call.

The U.S. economy grew at a 3.2 percent annual rate in the first three months of 2010, after growing at a 5.6 percent pace in the last quarter of 2009, according to a Commerce Department report last month.

Inflation Expectations

Pianalto said measures of current inflation, labor costs, and inflation expectations all lead her to conclude that inflation will remain “subdued” as the nation emerges from recession.

“Recent evidence I am seeing puts momentum on the side of disinflation, at least in the short run,” she said in her speech to the Economic Club of Pittsburgh and the Pittsburgh Stock and Bond Association.

Fed policy makers are watching as inflation continues to fall. The Cleveland Fed compiles a Median CPI index, which increased at a 0.6 percent annual rate in March, the lowest level in more than 40 years. The index reflects the median change in prices, rather than the weighted average of the traditional consumer price index.

“For the next couple of years, I expect employment levels to remain well below what I would consider full employment” and inflation will probably “only gradually drift up from its currently low level,” Pianalto said. “This outlook warrants exceptionally low levels of the federal funds rate for an extended period of time.”

Every Other Year

Pianalto said she wants the central bank to shrink its balance sheet after its assets ballooned to a record $2.34 trillion following the purchase of $1.25 trillion of mortgage-backed securities to bolster the housing market.

“I’m looking toward a goal of getting that balance sheet back to holding U.S. Treasuries only, and the size to be pre-crisis levels,” Pianalto said in response to audience questions. “We have to do that in a way that’s gradual, that doesn’t disrupt financial markets, that doesn’t disrupt the economic recovery.”

The U.S. economy will be restrained by the sovereign debt crisis in Europe and budget problems among state and local governments, she said.

The “situation facing state and local governments will be another drag on economic growth,” Pianalto said.

Highest Deficits

Concerns that nations with the highest deficits will struggle to meet the European Union’s austerity requirements may also harm the U.S. economy, she said. The decline in the euro will make European exports cheaper, potentially inhibiting the performance of U.S. manufacturers, Pianalto said.

“So that would be another damper on economic growth in the U.S.,” she said.

The Fed plans to release the minutes of the April 27-28 meeting of the Federal Open Market Committee tomorrow. The minutes will include the most recent economic forecasts of FOMC policy makers.

Fed presidents rotate voting on the interest rate-setting FOMC, with Pianalto voting every other year, including this year. Pianalto, 55, joined the Cleveland Bank in 1983 as an economist in the research department and has been president since 2003. The Cleveland Fed comprises all of Ohio, as well as western Pennsylvania, eastern Kentucky and six counties in West Virginia.

To contact the reporters on this story: Caroline Salas in New York at csalas1@bloomberg.net; Joshua Zumbrun in Pittsburgh at jzumbrun@bloomberg.net

To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net

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