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U.K. unemployment claims rose the least in a year in June, adding to evidence that the worst of the recession may have passed.

Jobless benefit claims climbed from May by 23,800 to 1.56 million, the highest level in 12 years, the Office for National Statistics said in London today. The median forecast of 29 economists in a Bloomberg News survey was for a 41,300 increase. Overall unemployment in the quarter through May increased by 281,000, the most since records began in 1971.

Prime Minister Gordon Brown is trying to pull Britain out of its worst economic contraction in five decades less than one year before the next election. Reports yesterday showed the housing market improved last month and retail sales rose from a year earlier, while Bank of England Deputy Governor Charles Bean said today the economy is probably “bumping along the bottom.”

“The second-quarter contraction won’t be as bad as the previous one,” said Amit Kara, an economist at UBS AG in London and a former Bank of England official. “The recovery will be there, though I think we should see unemployment increase at least until the middle of next year.”

The claimant-count increase on the month was the smallest since May 2008, the statistics office said.

Overall unemployment, measured by International Labour Organization standards, rose to 2.38 million, the most since 1995. The British Chambers of Commerce said last week that unemployment may reach 3.2 million by the middle of next year.

Global Comparison

The jobless rate on the ILO measure was 7.6 percent, the statistics office said. That compares with 9.5 percent in the U.S. and the euro region, and 5.2 percent in Japan.

Brown, who must call an election by next June, has seen voters’ support dwindle as the recession gathered pace. The opposition Conservative Party leads the ruling Labour Party by a 16 percentage-point margin, according to a YouGov Plc poll published in the People newspaper on June 28 fast cash.

Bean says the recession has probably reached a bottom, though he also told BBC Radio Leeds this week that the economic recovery may be a “long haul” and it’s “inevitable” unemployment will keep increasing. He also said that Brown’s government would allow the Bank of England to surpass the 150 billion-pound ($245 billion) ceiling for asset purchases by a “reasonable amount” if necessary.

Job Cuts

For now, companies are still planning to shed workers. British Airways Plc said yesterday that it must push through job and pay cuts for the airline to survive the recession. Corus, Europe’s second biggest steelmaker, may shed as many as 366 workers at a factory in northeastern England.

The job market will eventually improve if a recovery takes root. The economy’s pace of contraction probably slowed to 0.4 percent in the second quarter from 2.4 percent in the first three months of the year, according to the National Institute of Economic and Social Research.

The housing market improved last month as more real-estate agents and surveyors in London said prices rose than fell, the Royal Institution of Chartered Surveyors said yesterday. Same- store retail sales increased 1.4 percent from a year earlier, the British Retail Consortium said.

The prospect of further job losses is keeping wages down. Excluding bonuses, earnings grew 2.6 percent, the least since records began in 2001. Average earnings in the three months through May rose 2.3 percent from a year earlier, the statistics office said.

Hays Plc, the U.K.’s largest recruitment company, said last week it will freeze pay for all staff including executives after the amount of fees it collected declined at an increasing rate.

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U.S. Treasury Secretary Timothy Geithner said the global economy probably will suffer setbacks during its recovery as nations adapt to a loss of wealth and a surge in public debt.

“This crisis has been brutal in the extent and severity of damage to economies around the world,” Geithner said in the prepared text of a speech in Jeddah, Saudi Arabia. “Given the extent of damage to financial systems, the loss of wealth, the necessary adjustments to a long period of excessive borrowing around the world, it seems realistic to expect a gradual recovery, with more than the usual ups and downs and temporary reversals.”

Economies will need to start growing again before jobs can be created, he said. He also said credit conditions will remain “unusually tight,” even though markets have opened up somewhat in response to government actions.

The U.S. yesterday reported a $1.1 trillion budget deficit for the fiscal year that began Oct. 1. Geithner’s visit to Saudi Arabia and the United Arab Emirates, two of the oil-exporting countries that are the fourth-largest holders of Treasury debt, comes as the U.S. braces for a projected 2009 budget deficit of $1.8 trillion, more than four times the previous fiscal year’s $459 billion shortfall.

“The U.S. needs to raise a lot of debt over the coming months and at a time when there’s talk about the dollar’s status as a reserve currency, they need to convince people that hold the debt that the U.S. is committed to fiscal responsibility in the medium term,” said Eric Swats, Dubai-based head of asset management at Rasmala Investments, which has about $1.2 billion under management, in an interview ahead of Geithner’s visit.

U.S. Borrowing

The U.S. Treasury chief sought to address both concerns in his prepared remarks. He pledged that the U.S. would take steps to rein in its borrowing while also attempting to address health care, financial regulation and other long-term issues.

“The United States was on an unsustainable fiscal path before this crisis, and we will not succeed in establishing sustainable recovery without a credible commitment to address our long term deficits,” Geithner said.

At the same time, the U.S. understands it has responsibilities as a leader of the global economy, he said.

“Given the dollar’s role in the international financial system and the significant impact of the U cash advance.S. economy on global economic conditions, we fully recognize that the United States has a special responsibility to play,” Geithner said.

Global Response

Around the world, governments have taken steps to combat the financial crisis that have “substantially reduced the risk of much deeper and more prolonged global recession,” Geithner said. He said he sees several indications of stabilization and improving confidence in the U.S., along with “initial signs” of global progress.

European economies are shrinking more slowly and there are similar signs in Japan, Geithner said. He also said China is helping other Asian economies after successfully using government policy to increase demand. Growth prospects also are improving in Brazil and other parts of Latin America, he said.

Geithner praised Saudi Arabia’s efforts to diversify its economy away from energy-related businesses. Later today, he is scheduled to visit the city of Yanbu to attend an economic development event with King Abdullah, the U.S. Treasury said.

“The world has yet to fully appreciate the scale of ambition and investment we are seeing in the Kingdom and the Gulf region to lay the foundation for future growth,” Geithner said. “You are diversifying your economies to build a future less dependent on oil and natural gas.”

Iran Sanctions

Geithner’s first visit to the Mideast as Treasury chief is aimed at explaining to allies and trading partners the state of the U.S. economy and shoring up their support for efforts to stop Iran’s nuclear program, stabilize Iraq and quell violence in Afghanistan, U.S. officials, who declined to be identified, said in a briefing last week.

Geithner is visiting the U.K., Saudi Arabia, the United Arab Emirates and France this week. In addition to possible new sanctions on Iran, he’ll also discuss the global economy, the upcoming Group of 20 summit in Pittsburgh, Pennsylvania, and efforts to prevent terrorism financing, the Treasury officials said in a briefing with reporters in Washington. In Abu Dhabi tomorrow, he’s also scheduled to meet with officials from two sovereign wealth funds.

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Japan’s opposition party, leading in polls ahead of next month’s election, said the nation should consider shifting its $1 trillion of foreign reserves away from the dollar and buying International Monetary Fund bonds.

“In the medium to long term, we need to do what we can to avoid the risk of currency losses or economic turbulence that could result if the dollar were to swing,” Masaharu Nakagawa, the shadow finance minister in the Democratic Party of Japan, said in an interview in Tokyo on July 9. “Many countries are starting to diversify their reserves.”

Japanese investors are the biggest foreign holders of Treasuries after China with $685.9 billion of the securities in April, and Finance Kaoru Yosano said last month his trust in the bonds is “unshakable.” The DPJ yesterday beat the ruling Liberal Democratic Party in elections for Tokyo’s city assembly, boosting its prospects ahead of national polls that Prime Minister Taro Aso today called for Aug. 30.

“The current reality of Japan’s foreign-currency reserves is that their heavy weighting toward dollar assets means any fall in the dollar’s value leads to valuation losses,” said Susumu Kato, chief economist in Tokyo at Calyon Securities, the investment banking unit of Credit Agricole SA. “The DPJ is opposed to a foreign-currency reserve policy that is so wholly skewed to the dollar.”

The yen traded at 92.39 per dollar at 2:11 p.m. in Tokyo from 92.54 late July 10. It has gained 4.3 percent this month.

‘Unshakable’ Trust

Nakagawa said Japan should consider purchases of new bonds issued by the International Monetary Fund that will pay an interest rate pegged to the fund’s basket of currencies — the dollar, euro, yen and pound — and known as Special Drawing Rights. The dollar is the principal component of SDRs. The IMF said this month it would issue bonds to its 186 members for the first time.

“We should start considering that as an option,” Nakagawa said. “I am not saying we should do it right away. If everyone starts doing it all of sudden, it may sway the dollar.” He didn’t say Japan should sell any of its dollar holdings.

DPJ lawmaker Tsutomu Okubo, a director of the upper house’s financial committee, said there’s no consensus in the party on currency policy. Enhancing trust in the dollar and Treasuries is beneficial for Japan and the country shouldn’t change its currency reserve allocations for the time being, he said in an interview today.

China’s Reserves

China, India, Brazil, Mexico and South Africa last week challenged the U quick payday loans.S. dollar as the primary denomination of world reserves. In China, whose foreign-exchange reserves probably topped $2 trillion for the first time in the three months to June 30, Premier Wen Jiabao this year said he was concerned that his nation’s dollar assets may decline as the U.S. sells record amounts of debt to fund stimulus spending.

Japan holds $1.02 trillion in foreign reserves, also the world’s largest after China’s. Losses on the holdings stood at about 21 trillion yen ($227 billion) at the end of May, according to the Finance Ministry’s estimate.

Shifting reserves away from dollars “may be difficult for Japan” because it would weaken the U.S. currency and reduce the value of the country’s remaining dollar holdings, said Masafumi Yamamoto, head of foreign-exchange　strategy for Japan at Royal Bank of Scotland Group Plc in Tokyo.

“If Japan and China do that, the impact will be huge,” said Yamamoto, a former Bank of Japan currency trader.

Samurai Bonds

Nakagawa, 59, said Japan’s government should ask the U.S. to sell debt denominated in yen, so-called samurai bonds, as a way to diversify reserves and promote the globalization of the yen. Japan should also aim to strengthen the Chiang Mai Initiative, an Asia-wide foreign-reserve pool, and seek the creation of an Asian Monetary Fund, he said.

Nakagawa said intervening in the currency market to smooth abrupt and volatile moves is an option, though Japan shouldn’t try to push the yen up or down to achieve a prescribed level.

“If the yen were to appreciate or depreciate very steeply and the market becomes volatile, direct government intervention might be understandable,” Nakagawa said. “Intervention shouldn’t be used to strengthen or weaken it to a certain level.”

The yen gained against all 16 of the world’s major currencies in the past year. A stronger yen hurts Japanese exporters by making their products less competitive. It also lowers import costs for companies and consumers. Japan last stepped into the foreign-exchange market to sell yen in 2004.

Parliament will be dissolved July 21 to prepare for the lower-house election, Jun Matsumoto, deputy government spokesman, told reporters in Tokyo today.

A total of 23 percent of voters said they would choose the LDP, less than the 41 percent who favor the DPJ, according to a Yomiuri newspaper poll published July 10. The LDP has governed for all but 10 months since 1955. The DPJ already controls the upper house.

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Sentiment among U.S. consumers, whose spending is critical to an economic recovery, dropped in July after four months of gains as unemployment approached 10 percent.

The Reuters/University of Michigan preliminary index of consumer sentiment fell by more than forecast to 64.6 from 70.8 in the prior month. A separate report from the Commerce Department showed the trade deficit unexpectedly narrowed in May to the lowest level in almost a decade.

Unemployment is rising even as economists predict an end to the recession in coming months. Consumers in the survey said they are less likely to buy cars or appliances, suggesting that the recovery may be weaker than anticipated.

“There’s a lot of concern about job losses, and people think they won’t be able to earn more,” said Jonathan Basile, an economist at Credit Suisse Holdings Inc. in New York. “Until the employment picture clears up, we can’t anticipate persistent gains in consumer spending.”

The confidence index was forecast to dip to 70, according to the median of 59 economists surveyed by Bloomberg News. A gauge of expectations for six months from now, which more closely projects the direction of consumer spending, plunged to 60.9, the biggest drop since October, from 69.2.

The report helped send stocks lower, with the Standard & Poor’s 500 Index falling 0.4 percent to 879.13 for its fourth straight weekly loss. The Dow Jones Industrial Average declined 0.5 percent to 8146.52

Trade Deficit

The trade deficit narrowed 9.8 percent to $26 billion, the smallest gap since November 1999, from a revised $28.8 billion in April, today’s Commerce Department report showed. The gap was projected to widen to $30 billion, from an initially reported $29.2 billion in April, according to the median forecast in a Bloomberg News survey of 71 economists.

A shrinking deficit signals trade will add more to U.S. gross domestic product as exports to emerging economies such as Brazil increase. U.S. demand for imported auto parts was held down by production cutbacks and factory shutdowns by Detroit- based General Motors Corp. and Chrysler LLC, based in Auburn Hills, Michigan, two of the three largest U.S. automakers.

“Demand in the rest of the world is stabilizing sooner than in the U business cards.S.,” Basile said. “If it continues like this, trade could wind up adding to growth.”

A Labor Department report today showed prices of goods imported into the U.S. rose 3.2 percent in June, the fourth monthly gain, as oil costs jumped by the most in a decade.

Inflation Outlook

Consumers in the University of Michigan survey said they expect an inflation rate of 3 percent over the next 12 months, compared with 3.1 percent in the prior month’s survey. Over the next five years, the figures tracked by Federal Reserve policy makers, Americans expected a 3.1 percent rate of inflation, compared with their 3 percent forecast last month.

An index of current conditions, which reflects Americans’ perceptions of their financial situation and whether it is a good time to buy big-ticket items like cars, fell to 70.4 from 73.2.

Employers reduced payrolls by 467,000 last month, more than anticipated, government figures showed last week. Economists surveyed by Bloomberg this month predicted the unemployment rate will surge to 10 percent by the end of the year, from 9.5 percent in June.

The same survey said the economy will expand faster than previously forecast in the second half of this year and in 2010. Growth will average 1.5 percent in the July-to-December period, compared with last month’s 1.2 percent projection, according to the median of 57 forecasts taken from July 2 to July 8.

Retail Sales

Sales reports at retailers reflect caution among consumers, who are shifting purchases to discount stores.

June sales at stores open at least a year rose at Ross Stores Inc., the Pleasanton, California-based owner of the Ross Dress for Less discount chain, and Framingham, Massachusetts- based TJX Cos., owner of T.J. Maxx stores.

Same-store sales fell more than forecast for clothing retailers Abercrombie & Fitch Co., based in New Albany, Ohio, and Gap Inc., based in San Francisco.

The preliminary Reuters/University of Michigan consumer confidence report reflects about 300 responses, compared with 500 households for the final survey.

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The Bank of England’s emergency bond-buying program may end next month as Britain’s worst recession in a generation eases, economists say.

Officials decided yesterday not to expand the 125 billion- pound ($203 billion) spending plan and said they will pause purchases of government bonds at the end of July. That suggests they may be preparing to wrap up the policy, said Credit Suisse Group AG, Citigroup Inc. and Fortis Bank Nederland Holding NV.

“We’re at a turning point,” said Nick Kounis, an economist at Fortis in Amsterdam and a former U.K. Treasury official. “We know the economy has probably stabilized. Even though they can’t see the effects of what they’re doing, they may be starting to worry about overkill.”

Bank of England Governor Mervyn King will assess the plan’s success in August and any decision to finish it would shift the focus of policy to the exit strategy. While some economists are concerned creating too much money to buy the bonds will spark inflation, officials stress they can contain those risks by offloading the debt they have bought and raising interest rates.

In the U.S., the Federal Reserve has already started rolling back measures set up to stave off a deeper recession. The Fed said last month it will let one emergency-lending program expire this year and trim two others.

Bond Drop

Gilts dropped and the pound rose when the Bank of England declined to push its purchase plan to the 150 billion-pound limit authorized by Gordon Brown’s government. The yield on the benchmark 10-year bond jumped the most in three months, climbing 17 basis points yesterday. It advanced a further 7 basis points to 3.85 percent today.

The pound, which advanced 1.6 percent yesterday, slipped 0.5 percent to $1.6261 as of 8:46 a.m. in London. The central bank also left its benchmark interest rate at a record low of 0.5 percent.

“Not extending the program this month makes it more likely they will stop it next month,” said Michael Saunders, chief western European economist at Citigroup in London. “Growth prospects are better and the inflation outlook is higher. This may be cordoning off their scope to keep going.”

The U.K. inflation rate fell less than economists forecast in May and is still above the bank’s 2 percent target. Policy makers predicted in their May 13 forecasts that the rate will drop below target and won’t return to it in two years.

The bank’s concerns about deflation may yet lead them to expand the purchase plan car loan. Philippe-Henri Burlisson, an investor at Groupama Asset Management in Paris, said the inflation outlook will be “key” in policy makers’ thinking.

‘Signs of Stabilization’

“For them to stop would mean that they are convinced the economy is doing better enough,” Burlisson said. “I have a hard time believing this.”

Bank of England Deputy Governor Charles Bean said June 24 that it appeared that “it looks like we may be around the trough” of the slump, and policy maker Andrew Sentance said that “there are signs of stabilization, but it doesn’t tell us how strong the recovery will be.”

Gross domestic product slumped 2.4 percent in the first quarter, the most in 50 years, and data since then have been mixed. House prices dropped 0.5 percent in June after jumping 2.6 percent the previous month, Halifax says. Manufacturing fell in May for the first time in three months.

British Airways Plc, which reported the biggest loss in its history in the quarter ended March 31, may face strikes as the airline pushes unions to accept almost 4,000 job cuts.

Taking Root

The economy’s contraction eased to 0.4 percent in the second quarter, the slowest pace in a year, according to an estimate by the National Institute of Economic and Social Research. The International Monetary Fund this week raised its U.K. forecast for 2010 to predict a return to growth.

If a recovery takes root, the central bank’s “biggest challenge” will be determining the exit strategy from its emergency plan, according to Adam Posen, deputy director at the Peterson Institute for International Economics in Washington, who will become a U.K. policy maker in September.

Economists say rate increases are unlikely this year. Citigroup’s Saunders predicts the bank will lift the rate in the second quarter of 2010. Fortis’s Kounis said policy makers will wait until the second half before raising it “gradually.”

“The economy isn’t strong but the extreme risks quantitative easing was addressing have diminished,” said Robert Barrie, chief U.K. economist at Credit Suisse in London, and a former Treasury official. “It is the beginning of the end for QE.”

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Group of Eight leaders said the economic recovery from the steepest recession since World War II was too fragile for them to consider reversing efforts to pump money into the economy.

President Barack Obama pressed for the door to remain open to more stimulus measures as a renewed stock-market drop stirred concern that $2 trillion spent worldwide so far hasn’t jolted consumers and businesses back to life.

“The G-8 needed to sound a second wakeup call for the world economy,” British Prime Minister Gordon Brown told reporters yesterday in L’Aquila, Italy, after the opening sessions of the leaders’ annual gathering. “There are warning signals about the world economy that we cannot ignore.”

Divergences over what to do next and calls from developing nations to do more to counter the slump underscored the G-8’s limited room for maneuver. The biggest borrowing spree in 60 years has failed to halt rising unemployment and left investors doubting the strength of the recovery. The MSCI World Index of stocks slid for a fifth day. The 23-nation index has dropped 8 percent since a three-month rally ended on June 2.

“Economies still need as much stimulus as possible,” said David Page, an economist at Investec Securities in London. “It’s important not to react too soon to early signs of a pickup or take false comfort from them.”

IMF Forecasts

The International Monetary Fund echoed that skepticism, upgrading its 2010 growth forecast while saying the rebound will be “sluggish” and urging governments to stay the economic- stimulus course.

Emerging countries like China will lead the way, expanding 4.7 percent next year, the IMF said yesterday, up from an April prediction of 4 percent. The Washington-based lender forecast growth of 0.6 percent in the advanced economies, up from expectations of stagnation.

“It’s a very volatile situation,” European Commission President Jose Barroso said in a Bloomberg Television interview in L’Aquila. “We are not yet out of the crisis, but it seems now that the free fall is over.”

In the U.S., a jump in the jobless rate to a 26-year-high of 9.5 percent in June and a 6.9 percent drop in the Standard & Poor’s 500 Index in the past month raised questions whether Obama’s $787 billion stimulus package is turning the world’s largest economy around.

Democrats in Congress are split over whether to spend more, adding to a deficit that the IMF puts at 13.6 percent of gross domestic product in 2009, the highest since World War II.

‘Potentially Counterproductive’

Obama straddled the issue yesterday, telling ABC News that spending more borrowed money is “potentially counterproductive.”

A G-8 statement yesterday embraced options ranging from the second U.S. stimulus package some lawmakers and economists are advocating to Germany’s emphasis on shifting the focus to deficit reduction fast payday loans.

“Exit strategies will vary from country to country depending on domestic economic conditions and public finances,” leaders of the eight economies — the U.S., Japan, Germany, Britain, France, Italy, Canada and Russia — said in the statement.

“There is still uncertainty and risk in the system,” Mike Froman, deputy U.S. national security adviser, told reporters in L’Aquila. While exit strategies can be drawn up, it’s not “time to put them into place.”

Bank bailouts and recession-fighting measures will explode the debt of the advanced economies to at least 114 percent of gross domestic product in 2014, the IMF forecasts.

‘Exit Strategy’

German Chancellor Angela Merkel is the leading opponent of additional stimulus, pushing through a statement at last month’s European Union summit that called for “a reliable and credible exit strategy.”

Merkel, campaigning for re-election in September, has warned against billowing budget deficits, which will rise in the EU to an average of 6 percent of GDP in 2009 from 2.3 percent last year, the EU forecasts.

“We have to get back on course with a sustainable budget, but with the emphasis on when the crisis is over,” Merkel said.

The 16-nation euro economy has shown some signs of resilience since shrinking 2.5 percent in the first quarter, the most since the currency’s birth in 1999. While measures of business confidence, manufacturing and services have ticked up, job cuts by companies from Austrian Airlines AG to ThyssenKrupp AG pushed up unemployment to 9.5 percent in May, a 10-year high.

Asian Resilience

Further signs of a resilience also emerged in the Asia- Pacific region, where governments including China and Australia have boosted spending to increase economic growth. Australia’s jobless rate rose in June by less than forecast, climbing to 5.8 percent from 5.7 percent, a report showed today. Analysts tipped a 5.9 percent rate.

In China, new loans rose almost fivefold in June from a year earlier to 1.53 trillion yuan ($224 billion), the central bank said on its Web site yesterday. China’s passenger-vehicle sales rose 48 percent in June, the biggest jump since February 2006.

Canadian Prime Minister Stephen Harper occupied the middle ground, saying the first priority is to spend wisely what has already been committed.

“Before there’s talk of additional stimulus, I would urge all leaders to focus first on making sure that the stimulus that’s been announced actually gets delivered,” Harper said.

Russia, a G-8 member generally classified as an “emerging” economy, also believes that exit strategies “have to be developed already now,” said Andrei Bokarev, a Russian official.

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Goldman Sachs Group Inc. says when it comes to inflation, the Federal Reserve can relax. That kind of talk makes Morgan Stanley nervous.

Joachim Fels, co-chief global economist at Morgan Stanley, sees a risk that the Fed will keep the easiest credit since the Great Depression for too long. Ed McKelvey, U.S. economist at Goldman in New York, says those concerns are overblown, and that officials have time to deploy as many as 10 options for ending their $1.1 trillion aid to the banking system and economy without letting consumer prices climb.

The debate underscores a widening division among economists over whether the central bank will hold onto the gains it’s achieved in fighting inflation over the past three decades. Record liquidity injections and a projected federal budget deficit of $1.85 trillion threaten to undermine that legacy.

“The greater risk is they keep accommodation too long rather than tighten too quickly,” Fels, who’s based in London, said in an interview. “The price they would then pay is higher inflation for keeping the economy afloat.”

A measure of inflation expectations watched by Fed officials rose “closer to the 2 percent level” in recent months after being “very negative late last year,” St. Louis Fed President James Bullard said in a June 30 presentation in Philadelphia. He also said investors “are not expecting a lot of inflation over the next five years.”

The Fed’s preferred price gauge, which excludes food and energy prices, rose 1.8 percent in May from a year earlier. Fed officials expect inflation in a range of 1.7 percent to 2.0 percent over the longer term, according to minutes of April’s Federal Open Market Committee meeting.

Meltzer’s View

“I agree with Morgan Stanley that the markets are too sanguine about inflation,” said Allan Meltzer, a Fed historian and economics professor at Carnegie Mellon University in Pittsburgh. “The Fed absolutely has the tools and know-how, but the question is, will they have the guts to use them? I don’t think there is a snowball’s chance in hell they will be willing to tighten to slow inflation down.”

Goldman Sachs says the risk is in the other direction, that the Fed may have a tougher time easing credit further should the economy deteriorate. Jan Hatzius, the company’s chief U.S. economist in New York, said in a July 1 research note that it’s “very unlikely” the Fed will “lose control” of inflation and that the Fed should err on the “accommodative side” of monetary policy.

‘Screw-Up’ Scenario

“The market seems to have a bias in its thinking that somehow the Fed is going to totally screw up,” resulting in inflation, McKelvey, who used to work at the Fed, said in an interview. He cited conversations with clients and what he’s read in the press, as well as the rise in Treasury yields and trader expectations of Fed interest-rate increases in recent weeks.

McKelvey, who wrote a June 30 note outlining the Fed’s options, cautioned there’s no guarantee the Fed will get it right, and “political constraints” might prevent the central bank from using its tools.

The Fed lowered its main interest rate almost to zero in December, switching to asset purchases and credit programs as the main policy levers. Chairman Ben S. Bernanke is leading plans to buy as much as $1.25 trillion of mortgage-backed securities and $200 billion of federal agency debt by year-end, along with $300 billion of long-term Treasuries by September cash advance.

Bernanke’s Options

Bernanke has three sets of tools, about 10 options total, for unwinding credit, McKelvey said. They include the reduction or end of non-emergency and emergency lending programs; selling or ceasing purchases of securities; and reducing bank reserves using tools such as the issuance of Fed debt.

“This one’s easy: Morgan Stanley is wrong and Goldman is right,” said Mark Gertler, a New York University economist and research co-author with Bernanke. “The Fed will be able to contain inflation pressures through a combination of raising interest rates and unwinding its balance sheets.”

The expansion of the Bank of Japan’s balance sheet also had no effect on inflation in that country, Gertler said.

The Fed took a first step last month toward ending its efforts to revive credit, deciding to let one emergency lending program expire and trim two others. Bullard said last week that policy makers need to craft a broader plan for unwinding the asset purchases to reduce inflation risks and bolster confidence in an economic recovery.

“The Fed needs to reduce some of the uncertainty in markets about how the exit strategy looks,” said Fels. “They can’t tell us when, but there needs to be more transparency on the how.”

Interest on Deposits

Some top Fed officials have said they plan to rely on raising the rate paid on banks’ deposits with the Fed as a major component of the central bank’s strategy to tighten credit.

Bernanke has a chance to give a more detailed outline of the Fed’s exit strategy on July 21, when he delivers the Fed’s semiannual monetary policy report to Congress and testifies before the House Financial Services Committee.

The Fed has increased total assets on its balance sheet by $1.1 trillion in the past year to $2.01 trillion as of July 1 to unfreeze credit markets and support banks’ demand for cash. Short-term lending to commercial banks and bond dealers has declined in recent weeks, owing in part to falling costs for private borrowing.

Yellen Warning

Goldman’s views may be shared by some Fed officials. San Francisco Fed President Janet Yellen said in a June 30 speech to the Commonwealth Club of California that the “predominant risk” is that inflation will “be too low, not too high, over the next several years.”

Inflation excluding food and energy may fall to about 1 percent over the next year and remain below 2 percent, with an unlikely possibility of turning into deflation if the economy fails to recover soon, Yellen said.

Another Fed district bank president, Charles Evans of Chicago, told reporters in London on July 1 that he also sees inflation falling “a bit from where we are now.”

“I don’t worry about the technical ability of the Fed to do it,” Martin Feldstein, a professor of economics at Harvard University, said in a Bloomberg Radio interview July 1. “What worries me is the political hurdle that they would be facing.” Congress won’t “easily” digest the Fed’s desire to limit lending and restrict inflation, Feldstein said.

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Australia’s trade deficit widened in May as a drop in coal shipments pushed exports to the lowest level in 14 months, signaling economic growth may slow.

The shortfall swelled to A$556 million ($448 million) from a revised A$282 million in April, the Bureau of Statistics said in Sydney today. The median estimate in a Bloomberg survey of 20 economists was for a A$125 million gap. Exports fell 5 percent.

Prices for iron ore and coal have declined, damping a mining boom that drove Australia’s 17-year economic expansion. BHP Billiton Ltd., the world’s biggest mining company, and Rio Tinto Group have pared output, fired workers and cut capital expenditure in response to the slowdown in world demand.

“The global recession is starting to hit Australian export income,” said Su-Lin Ong, a senior economist at RBC Capital Markets in Sydney. “That will flow through the economy. Growth is likely to be weak and patchy in the quarters ahead.”

Australia avoided a technical recession in the first quarter as government stimulus and interest-rate cuts stoked consumer spending. The economy expanded 0.4 percent from the fourth quarter, when it shrank 0.6 percent.

The Australian dollar traded at 80.63 U.S. cents at 12:28 p.m. in Sydney from 80.76 cents before the report was released. The two-year bond yield was little changed at 3.87 percent.

Imports fell 4 percent to A$20.95 billion from April. Imports of capital goods, such as trucks and machinery, dropped 14 percent and consumer goods slipped 1 percent.

Coal Prices

Exports declined to A$20.39 billion, the lowest since March 2008. Shipments of non-rural goods, which include metals and minerals, fell 5 percent. Agricultural sales dropped 3 percent. Coal sales slumped 15 percent and shipments of cereals declined 7 percent.

BHP Billiton agreed to a 58 percent cut in annual coking coal contract prices after demand for the steelmaking material fell, according to a company statement last month.

“Changes in annual contracts and pricing arrangements are expected to flow through to export prices over a number of months,” Australia’s central bank said in a report this week cheap payday loans.

Rio Tinto, the world’s second-largest iron-ore exporter, agreed to a 33 percent cut in contract prices with Japanese and Korean steelmakers this year. It has yet to agree on prices with China, the world’s biggest consumer of iron ore. BHP Billiton has yet to announce any agreed contract prices this year.

Investment Drop

Australian businesses cut spending on machinery and equipment in the first quarter by 9.6 percent, the most since 1991, amid faltering global demand. Rio Tinto slashed its global spending by more than half to $4 billion this year and BHP shut its $2.2 billion Ravensthorpe nickel mine.

Still, even as miners are buffeted lower commodity prices, a recovery in global demand may support Australia’s export earnings.

Reports this week show China’s manufacturing expanded for a fourth month, Japan’s business confidence improved and South Korea’s factory production climbed for a fifth month. China and Japan are Australia’s largest export markets.

“We are seeing better economic numbers out of our major trading partners and that’s good news for exports,” said Michael Blythe, chief economist at Commonwealth Bank of Australia in Sydney. “That will help mitigate the decline in export prices.”

Macarthur Coal Ltd., the world’s biggest exporter of pulverized coal used in steelmaking, has received increased sales inquiries this year from China, not a traditional export market for Australian coal, Shane Stephan, chief development officer, said last month.

“We historically have never sold coal into China at all and just since February there has been increasing levels of inquiry from China,” he said. “That’s the major change.”

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