Fed expects economy to keep improving

NEW YORK (CNNMoney.com) -- The Federal Reserve has a more optimistic outlook for the U.S. economy, according to meeting minutes released Wednesday, but the central bank is still debating how to shrink its massive balance sheet.

The Fed now expects U.S. gross domestic product, the broadest measure of economic activity, to increase at an annual rate of between 3.2% and 3.7% in 2010. That's up from the Fed's previous estimate of between 2.8% and 3.5% in January.

GDP rose at a 3.2% annual rate in the first three months of this year, the government said last month.

At the same time, the Fed reduced its forecast for the nation's unemployment rate to a range between 9.1% and 9.5% this year, versus 9.5% to 9.7% in January. The unemployment rate currently stands at 9.9%.

The minutes were from the Fed's most recent Open Market Committee meeting, which took place last month. That meeting happened before the financial markets were rocked by an escalation of fears about the economic crisis in Europe.

Still, Fed members also acknowledged the growing turmoil in Europe leading up to its last meeting, noting that "fiscal strains in Greece intensified during the intermeeting period."

The Fed subsequently announced plans to expand currency swaps with the European Central Bank and other central banks in the region to help contain the crisis.

When will the Fed raise rates? Despite the improved outlook, the Fed cautioned that the U.S. economy remains vulnerable enough to maintain an "accommodative stance of monetary policy."

In addition, committee members discussed ways to reduce the central bank's balance sheet, which swelled during the financial crisis as the Fed bought billions worth of government and corporate bonds.

In March, the Fed completed a $1.25 trillion program to buy mortgage bonds backed by government-sponsored lenders. It also purchased about $175 billion of agency debt.

Last year, the Fed bought $300 billion of long-term U.S. Treasury bonds to help keep mortgage rates down.

"Meeting participants agreed broadly on key objectives of a longer-run strategy for asset sales and redemptions," according to the minutes. "Reducing the size of the balance sheet would decrease the associated reserve balances to amounts consistent with more normal operations of money markets and monetary policy."

But the minutes showed that Fed bankers had a variety of opinions on how and when to begin selling the securities. Most members wanted to delay asset sales "for some time," but a few members preferred to begin sales "relatively soon."

A majority of members were in favor of selling assets gradually over a period of five years -- but not until after the Fed begins increasing interest rates since that would mean the economic recovery is firmly established.

If that's the case, the Fed may not wind up selling any of these assets anytime soon. The Fed also lowered its outlook for inflation, suggesting the central bank will be able to maintain the low interest rate policy it has had in place for over two years.

In April, the FOMC voted to hold the federal funds rate, its key overnight lending rate, near 0%. At that time, the Fed said it expects to keep rates "exceptionally low" for an "extended period" -- which has been the central bank's mantra for months.

However, one member of the committee voted against holding rates low indefinitely.

Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, indicated that rates should be increased toward 1% this summer, at which time the Fed could "further assess the economic outlook," according to the minutes.