The Fed said it will cut its monthly bond purchases starting in February by $10 billion to $65 billion. It also reaffirmed its plan to keep short-term rates at record lows to try to reassure investors that it will keep supporting an economy that remains less than fully healthy.
The decision by the Fed was announced in a statement Wednesday after Ben Bernanke's final policy meeting. Bernanke will step down Friday after eight years as chairman and will be succeeded by Vice Chair Janet Yellen.
Most economists expect that under Yellen, the Fed will announce a string of $10 billion monthly reductions in bond purchases at each meeting this year, concluding with a final $15 billion cut in December.
Many global investors fear that reduced Fed bond buying will boost U.S. rates and cause investors to move money out of emerging markets and into the United States for higher returns. Currency values in emerging economies have fallen over that concern.
In response, central banks in emerging economies, from India to Turkey to South Africa, have been acting to counter any damage from the Fed's pullback and the prospect of higher U.S. rates: They've been raising their own rates. These central banks hope to control inflation, boost their flagging currencies and keep investors from fleeing.
But so far, those currencies have continued to weaken.
The Fed's bond purchases have been intended to keep long-term borrowing rates low to spur spending and growth. Its decision Wednesday to continue paring purchases signals the Fed's belief that the economy is showing consistent improvement. In its statement, it upgraded it assessment to say "growth in economic activity picked up in recent quarters."
Stocks fell after the Fed announced its decision. Bond prices rose slightly, and their yields dipped.
The Dow Jones industrial average closed down 189 points, or 1.2 per cent. It had been down 127 points just before the Fed's announcement at 2 p.m. Eastern time. Disappointing earnings from big U.S. companies had contributed to a sour mood on Wall Street. The yield on the 10-year Treasury note slipped to 2.68 per cent.
Some analysts said the Fed's confidence in the U.S. economy appeared to outweigh any concern that the turmoil in emerging market economies might spill over into the United States and other developed nations.
"These economies have not been driven into deep recession," Ian Shepherdson, chief economist at Pantheon Macroeconomics, said of the emerging economies. "Their currencies are weak but not in freefall."
The Fed made no mention of the turbulence that has rocked markets for the past week. In part, that reflects the Fed's role as a steward of the U.S. economy, not the global economy as a whole: Its dual mandate is to maximize U.S. employment and keep U.S. prices stable.
Its bond purchases have helped fuel a huge stock market rally over the past year as investors shifted money out of low-yielding bonds and into stocks. Now that the Fed is cutting back on those bond purchases, many investors fear stocks will fall.
"Ultimately, the Fed sort of had no choice but to reduce purchases at this meeting," said Dan Greenhaus, chief strategist at BTIG brokerage. "If they had paused, they risked sending a signal to markets that they lacked conviction."
The action Wednesday was approved on a 10-0 vote. The last time a Fed policy statement was approved unanimously was June 2011.
The Fed's statement repeated a phrase it first used in December: That it would hold its benchmark short-term rate near zero "well past" the time unemployment falls below 6.5 per cent. The Fed noted that government spending cuts and tax increases are less of a drag on growth than last year. It also said businesses and consumers are stepping up spending.
The unemployment rate dipped from 7 per cent to 6.7 per cent in December, the lowest point in five years. Still, much of the decline was due to an exodus of job seekers who gave up looking for work and were no longer counted as unemployed.
AP Economics Writer Josh Boak contributed to this report.