The Federal Reserve will start moving away from its zero interest rate policy later this year as the U.S. economy improves modestly and job growth resumes, the UCLA Anderson Forecast unit said on Wednesday.

Simply put, the financial emergency of 2007-09 is over and we believe that the Fed will soon recognize this reality, the unit said in a report. To be sure, interest rates will remain historically low throughout 2011, but the way will be open to more normal interest rates.

As rates rise, employers uncertain about costs that may arise from new policies in Washington, including federal healthcare legislation signed on Tuesday by President Barack Obama, will cautiously rebuild payrolls, keeping unemployment above 9 percent through next year, the unit predicted.

We forecast that the unemployment rate will be 9.6 percent at the end of 2010, just a tad lower than where it is today and 9.1 percent at the end of 2011, the report said.

Job growth will struggle to stay barely ahead of work force growth. Furthermore, with the modest employment growth we are forecasting, payroll employment will still be 2 million jobs below its peak in 2007 by the end of 2012, the report said.

It just shows how deep of a hole the economy dug for itself, said David Shulman, a senior economist with the UCLA Anderson Forecast unit.

Helped by low interest rates and the beginning of a jobs recovery, equipment for manufacturing, information technology and energy along with software, exports and housing will propel growth this year and next, it said.

After a stunning inventory-led 5.9 percent increase in real GDP in the fourth quarter of 2009, we expect the economy to grow at a 3.2 percent rate in the current quarter and continue to grow at a 2 percent-plus rate for the remainder of the year, the report said.

Moreover, real GDP is forecast to grow at a 2.3 percent and 3.2 percent pace in 2011 and 2012, respectively, it added.

INFLATION CONCERNS

Growth would be stronger if not for weakness in nonresidential construction, state and local government finances and consumer spending, the report said.

The UCLA Anderson Forecast unit does not expect nonresidential construction to recover until the second half of 2011 and said that ongoing restructuring of state and local government represents a fundamental structural adjustment.

Like state and local governments, consumers will likewise mind their spending. To be sure, consumer spending will be growing, but the 2 percent or so growth that we are forecasting will be far less ebullient than the 2005-07 housing bubble era, the report said.

Despite the modest growth forecast by the unit, it is concerned inflation pressures are building and believes the Fed shares that view despite expectations for continued high unemployment and tepid growth.

By way of analogy, the Fed's monetary policy has strewn kindling wood throughout the economy that could ignite into inflation at any time, the unit's report said.

Presently, the kindling is wet and is in no danger of ignition, but in a few years that might not be the case. We believe that the Fed understands this risk and that is why we believe policy will be tightened this year, it said.

The unit sees inflation under control through next year. Nevertheless, core CPI is forecast to be modestly in excess of the Fed's historic target of 2 percent in 2012, the report said.

At the same time, the unit sees yields on U.S. benchmark 10-year Treasury notes gradually rising above 4 percent later in the year. Modest increases will follow.

Indeed, the deficits arising from the financial crisis and its hangover will exert upward pressure on interest rates for a long time to come, the report said.

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