BUSINESS

Fed sticks with bond purchases but offers brighter outlook for the economy

06/19/2013 02:07 EDT | Updated 08/19/2013 05:12 EDT
WASHINGTON - Chairman Ben Bernanke ended weeks of speculation Wednesday by saying the Federal Reserve will likely slow its bond-buying program later this year and end it next year because the economy is strengthening.

The Fed's purchases of Treasury and mortgage bonds have helped keep long-term interest rates at record lows. A pullback in its $85 billion-a-month program would likely mean higher rates on mortgages and other consumer and business loans.

Speaking at a news conference after a two-day Fed meeting, Bernanke said the reductions would occur in "measured steps" and that the bond purchases could end by the middle of next year. By then, he thinks unemployment will be around 7 per cent.

The chairman likened any reduction in the Fed's bond purchases to a driver letting up on a gas pedal rather than applying the brakes. He stressed that even after the Fed ends its bond purchases, it will continue to maintain its vast investment portfolio, which will help keep long-term rates down.

The ultra-low borrowing rates the Fed has engineered have been credited with helping fuel a housing comeback, support economic growth, drive stocks to record highs and restore the wealth America lost to the recession.

Anticipating higher rates, investors reacted Wednesday by selling both stocks and bonds. The Dow Jones industrial average closed down 206 points. The yield on the 10-year Treasury note shot up to 2.33 per cent from 2.21 per cent.

"There's fear you'll see an expanding economy, which has a tendency to push up interest rates," said Jack Ablin, chief investment officer of BMO Private Bank.

Some investors worry that higher rates will cause investors to shift money out of stocks and into higher-yielding bonds. Others fear that the economy might not be ready to absorb higher rates and that consumers and businesses could pull back on borrowing.

Talley Leger, a strategist at Macro Vision Research, said investors had become hooked on the Fed's efforts to keep rates at record lows.

"Markets are asking for expansion of already stimulative policies, and they're not getting it," Leger said. "It's like drug supplier and an addict."

After its two-day policy meeting ended Wednesday, the Fed issued an updated economic forecast, which sketched a brighter outlook. And in a statement, it said the "downside risks to the outlook" had diminished since fall. Fed members voted to continue the pace of its bond-buying program for now.

At his news conference, Bernanke suggested that increased home prices and household wealth, a stronger construction industry and steady consumer spending would help support economic growth and offset higher mortgage rates.

"Generally speaking, financial conditions are improving," he said.

The Fed's more upbeat forecast helps explain why it thinks record-low rates may soon no longer be necessary. Low rates help fuel economic growth. But they also raise the risk of high inflation and dangerous bubbles in assets like stocks or real estate.

Timothy Duy, a University of Oregon economist who tracks the Fed, called its statement "an open door for scaling back asset purchases as early as September."

The fact that the Fed foresees less downside risk to the job market "gives them a reason to pull back" on its bond purchases, Duy said.

Asked at his news conference whether it will be difficult for the Fed to clearly communicate its plans for scaling back the bond purchases, Bernanke agreed.

"We are in a more complex type of situation," he said. "We are going to be as clear as we can."

In its statement, the Fed also said it would maintain its plan to keep short-term rates at record lows at least until unemployment reaches 6.5 per cent.

In its updated economic forecast, Fed officials predicted that unemployment will fall to 7.2 per cent or 7.3 per cent at the end of this year from 7.6 per cent now. They think the rate will be between 6.5 per cent and 6.8 per cent by the end of 2014, better than its previous projection in March of 6.7 per cent to 7 per cent.

The Fed also said inflation was running below its 2 per cent long-run objective, but noted that temporary factors were partly the reason. It said inflation could run as low as 0.8 per cent this year. But it predicts it will pick up next year to between 1.4 per cent and 2 per cent.

David Robin, co-head of the futures and options desk at the brokerage Newedge, said he didn't think Bernanke's upbeat assessment matches an economy that's just "muddling along."

Investors may suspect the Fed is looking for a reason to scale back the bond purchases, Robin said. "It's a big mess," he said.

The statement was approved on a 10-2 vote. James Bullard, the president of the Federal Reserve Bank of St. Louis, objected for the first time this year, saying he wanted a stronger commitment from the Fed to keep inflation from falling too low.

Esther George objected for the fourth time this year, again voicing concerns about inflation rising too quickly.

At his news conference, Bernanke declined to address speculation that he will step down as Fed chairman when his term ends in January.

He was asked to respond to comments Monday by President Barack Obama, who said Bernanke had already stayed longer than planned. The president's remarks added to expectations that Bernanke intends to step down.

Bernanke avoided the question.

"I would like to keep the discussion on monetary policy," he said. "I don't have anything for you on my personal plans."

David Jones, chief economist at DMJ Advisors, suggested that Bernanke had achieved a key goal Wednesday: Clearing up the confusion he'd created when he sent a mixed message to Congress last month about when the Fed might start to slow its bond buying program.

"What Bernanke did was clarify" when it will taper its bond purchases, Jones said.

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AP Business Writers Paul Wiseman and Christopher S. Rugaber in Washington and Bernard Condon in New York contributed to this report.