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Fed officials say US recovery firm but watching Europe

Europe's debt debacle poses some risks for the United States, but is unlikely to derail the country's solid economic recovery, top Federal Reserve officials said. Financial markets have grown nervous in recent months about the possibility that some European countries might have trouble repaying their debts, potentially setting off a renewed banking sector crisis.

Fed Governor Kevin Warsh, while acknowledging a recent softening of the economic data, argued the US rebound would persist. He said the US economy is in a cyclical recovery and there are "encouraging" signs of improvement in financial markets.

Jeffrey Lacker, president of the Richmond Federal Reserve Bank, struck much the same note.

In an interview with Reuters on Monday, Lacker said a solid US economic recovery might soon enable the US central bank, to drop its promise to keep interest rates low for an “extended period.”

"The expansion is on track,” Lacker said. “Consumer spending continues to expand at a reasonably strong pace given the circumstances. We continue to see strength in business spending on equipment and software. Those are going to bring the economy forward.”

Despite recent rumblings in credit markets, which have been accompanied by a spike in the cost of interbank borrowing, a larger shock to the US financial system from European banks was improbable, he said.

Asked about the threat of deflation, Lacker said renewed concerns were overblown.

In response to the worst financial crisis in generations, the Fed slashed overnight borrowing costs close to zero in December 2008, where they remain. Officials have begun drafting an eventual blueprint to change policy, but are still reluctant to withdraw too quickly.

“We are in the exit stage,” Warsh said, pointing to the end of liquidity facilities the Fed put in place during the financial crisis.

In a separate interview with Reuters published over the weekend, St. Louis Fed Bank President James Bullard said policymakers would have to wait until the end of summer before knowing the full extent of Europe's impact on the United States.

“We want to see what the impact of this is on the US and see through the summer how this is going to play out,” he said.

“The data's been a little weaker, so let's wait and see. At this point, we're not in any hurry. Inflation readings have been low anyway,” he added.

Indeed, while gross domestic product has been expanding since last summer, inflation has remained quite tame. Consumer prices outside food and energy rose just 0.9% in the year to May, well below the Fed's presumed target of around 2%.




Warsh, in a speech in Atlanta on Monday, said “some” believe the Fed should do more to support the sluggish recovery, including buying more securities, as it did extensively during the financial crisis.

But at the moment, Fed officials still appear reluctant to resort to what would amount to a policy about-face.

"Any judgment to expand the balance sheet further should be subject to strict scrutiny,” he said.

Fed credit to the banking system, also known as the central bank's balance sheet, more than doubled since the onset of the financial crisis to over $2.3 trillion.

A major escalation of euro zone sovereign debt problems would be significant concern, Bullard said, adding that he sees the possibility of that as small. However, rattled confidence in the euro has actually benefited the United States in the form of lower long-term interest rates as nervous investors rush to the shelter of the dollar, he said. (Reuters)