Financial Watch

The U.S. economic recovery is on track and labor data should look better moving forward but more banks will fail this year than in 2009, said James Bullard, president of the Federal Reserve Bank of St. Louis.

“The situation is improving,” Bullard said in an interview with Dow Jones Monday, adding that “the recovery is on track.” Household spending is looking better and business investment is picking up, he added.

Bullard, however, doesn't expect a V-shaped recovery–meaning rapid economic growth–because of the “damaged” financial sector. He expects to see more bank failures this year than next, mainly due to banks' exposure to commercial real estate.

Bullard, a voting member of the Federal Open Market Committee this year, voiced some optimism on jobs, expecting better labor reports starting in March.

“I think [businesses] will get caught short with not enough workers to meet demand,” Bullard said, which could result in hiring from the private sector in addition to the jobs created by the government for the 2010 census.

He said he expects the unemployment rate to “tick down” throughout the spring, although the drop “won't be dramatic.”

On the housing sector, Bullard said the current data are mixed. “That's making me a little nervous,” he said. Still, he noted that housing activity is skewed in the winter, and that the March-to-June data are key to seeing how housing is performing. He expects housing to stay “at low levels,” maybe moving sideways or a bit higher. “I certainly don't expect it to boom,” he said.

Bullard also said that though the Fed is on track to end its $1.25 trillion purchase program for mortgage-backed securities, it continues to leave open the option of returning if the housing market needs it.

Bullard expects the program to end smoothly, with the market already transitioning to trading without the Fed's dominant presence on a daily basis. The Fed has pared down its weekly purchases to about $10 billion, from a high of $25 billion to $30 billion at its peak. The central bank has $14 billion left to purchase in the next couple of weeks, according to latest data from the central bank.

“Yields haven't opened up, and we don't expect much to happen at the end of month, or at the end of program,” he said. “All indications are that it's going to be a seamless transition.”

Further, the Fed will continue to use a portion of the $5 trillion mortgage-backed securities program, called dollar rolls, “to taper its exit,” Bullard said.

Dollar rolls are financing vehicles for owners of mortgage collateral, who give the bonds to dealers for cash, and get like securities back a month later. This is an important part of the $5 trillion agency mortgage world, and is key to maintaining liquidity. While the rolls don't have a direct impact on mortgage rates, they determine what securities investors buy and sell.

Bullard also said that inflation expectations are key for monetary policy and more important than any feedback on inflation from the real economy. “We have to reinforce our message that we intend to keep inflation low and stable,” he said. “If we start to lose the confidence of the market then we have to take actions to reinforce those expectations.”

The current gap between Treasury inflation-protected securities, or TIPS, and nominal Treasurys doesn't show expectations building yet, he said. The 10-year gap, known as the breakeven rate, was Monday at 2.20 percentage points, implying investors see an inflation rate of 2.20% on average in the next decade.

Bullard prefers looking at inflation expectations over the consumer price index because of problems in how the CPI measures total inflation. In particular, the housing collapse has brought down the price readings on shelter, which comprises a large proportion of the total and core CPI.

The central banker repeated his view that the use of the phrase “extended period” in connection with interest-rate policy has put the Fed in a box. He would prefer switching the wording to show policy decisions will be guided by the data rather than a time limit.

The phrase is “giving a misperception about what the committee really thinks,” Bullard said. “I think we possibly could improve communication by making a move in that direction” of dropping the language, he said. “I think there's probably more support [for that] than you think.”

Bullard defended the Fed's role in overseeing small banks, a task that could be taken away under the new financial changes being discussed in Congress. “In order to make good monetary policy, you should have good connections to these smaller lenders,” he said.

But he said that a “blueprint” is needed for the future of government-backed housing finance giants Fannie Mae (FNM) and Freddie Mac (FRE). “The sooner we deal with them, the better,” he said. “Their status right now is hard to get your head around.”

When asked about the roots of the credit freeze and economic crisis, Bullard–who took over at the helm of the St. Louis Fed in April 2008–said that it was caused by “the failure of financial engineering.” He said there wasn't enough information available to accurately price these complex securities.

He cautioned that any new financial regulations must allow the Fed to see the entire “financial landscape,” adding that in any crisis, “the central bank is going to have to be the lender of last resort.”

“The central bank needs to have a good understanding of that whole landscape and use that information the next time a crisis comes,” Bullard said.

Looking ahead, Bullard is confident that Europe will come to an agreement over Greece's fiscal dilemma. He also worries about bubbles, but doesn't see one developing now.