updated 7/16/2009 9:25:16 AM ET 2009-07-16T13:25:16

The Federal Reserve expects the economy this year will sink at a slower pace than it previously thought, but that unemployment will top 10 percent and remain high for the next few years, according to a new forecast released Wednesday.

Major Market Indices

The Fed now predicts the economy will shrink between 1 and 1.5 percent this year, an improvement from its old forecast issued in May. At that time, the Fed projected the economy would contract between 1.3 and 2 percent.

The upgrade — which helped major stock indicators jump about 3 percent and the Dow Jones industrial average to add 257 points — comes from the expectation that the economy’s downhill slide in the first half of 2009 wasn’t as bad as previously thought. The Fed said the economy should start growing again in the second half of this year, although the pace is likely to be plodding.

In fact, most Fed policymakers said it could take “five or six years” for the economy and the labor market to get back on a path of full health in the long term. And, most officials saw “the economy as still quite weak and vulnerable to further adverse shocks.”

Against that backdrop, the Fed’s forecast for unemployment this year worsened. The central bank predicted the jobless rate could rise as high as 10.1 percent, compared with the previous forecast of 9.6 percent.

The nation’s unemployment rate climbed to 9.5 percent in June, a 26-year high.

The predictions are based on what the Fed calls its “central tendency,” which exclude the three highest and three lowest forecasts made by Fed officials. The central bank also gives a range of all the forecasts. That range showed that some officials expect the jobless rate could rise as high as 10.5 percent this year, and 10.6 percent in 2010. The post-World War II high was 10.8 percent at the end of 1982, when the country had suffered through a severe recession. The jobless rate averaged 5.8 percent last year.

For 2010, the Fed predicted the economy would grow between 2.1 and 3.3 percent. That’s a slight upgrade from its old forecast of growth between 2 and 3 percent.

The Fed’s estimate is based on comparing projected activity in the fourth quarter of one year to the same period a year earlier. The economy dipped 0.8 percent in 2008 by that measure.

Still, it would mark a slow recovery and that will keep unemployment elevated well into 2011, the Fed said. Companies won’t be in any mood to ramp up hiring until they are certain that any recovery has staying power. Some Fed officials predicted the jobless rate could hover in the 8 percent range or as high as 9.2 percent in 2011.

To help lift the country out of recession, the Fed has slashed interest rates to a record low near zero. In March, the Fed launched a $1.2 trillion effort to drive down interest rates to revive lending and get Americans to spend more freely. Those actions — along with President Barack Obama’s $787 billion stimulus package of tax cuts and increased government spending — should help the economy return to growth in the second half of this year.

Fed officials at their June meeting observed “the economic contraction was slowing and that the decline in activity could cease before long.” Consumer spending appeared to have stabilized, new-home sales were flattening out and declines in capital spending did not look as severe as they had at the beginning of the year.

At the June meeting, Fed Chairman Ben Bernanke and his colleagues pledged to hold its key bank lending rate near zero for an extended period of time to help brace the economy. Many analysts believe the Fed will leave rates at record lows through the rest of this year.

The Fed last month also decided against expanding its $1.2 trillion program of buying government bonds and mortgage-backed securities to drive down rates on mortgages and other consumer debt.

Part of the reason the Fed stayed the course was out of fear that expanding the programs could stir up investor fears that the central bank’s aggressive actions could spur inflation later on, documents of the closed-door June meeting indicated. In addition, “it seemed that economic activity was in the process of leveling out.”

On the inflation front, Fed policymakers did bump up their forecasts for this year and next. The Fed expects inflation to rise between 1 and 1.4 percent in 2009, reflecting the influence of higher oil and commodity prices. The old forecast called for a gain of between 0.6 and 0.9 percent this year.

Even with the projected pickup, the Fed believes inflation “would remain subdued for some time” and be lower than the 1.9 percent increase logged in 2008. The sluggish recovery, idle plants, a weak employment market and cautious consumers will restrain companies from jacking up prices.

Next year, inflation should rise between 1.2 and 1.8 percent, the Fed said. That’s up from the old forecast of between a 1 and 1.6 percent gain.

Several Fed participants, though, worried that investors and consumers might start to expect that prices will march higher if the central bank’s aggressive steps to stimulate the economy “were not unwound in a timely fashion as the economy recovers.”

Copyright 2009 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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