Fed's bond buying could slow this fall

Paul Davidson | USA TODAY

WASHINGTON — The Federal Reserve said Wednesday it will keep its "easy money" policies going full tilt for now, but said for the first time that it might begin winding them down later this year.

In a statement after a two-day meeting, the Fed said it will continue to buy $85 billion a month in Treasury bonds and mortgage-backed securities until the labor market improves substantially. The purchases, launched last year, are intended to hold down long-term interest rates and have fueled the recent housing rebound and a blazing stock market rally.

Fed Chairman Ben Bernanke laid out a possible roadmap for reducing and then ending the bond purchases at a news conference following the meeting. If the economy and job market continue to improve, Bernanke said a gradual tapering down of the bond purchases could begin "later this year" with continued reductions next year until they stop in mid-2014, assuming the unemployment rate, now 7.6%, falls to about 7% by then.

However, Bernanke emphasized that such a strategy depends on the economy and job market. If they falter, the Fed could stop scaling back the bond purchases or even increase them again.

"If the economy does not improve along the lines we expect, we will provide additional support," he told reporters.

Markets have been in turmoil since Bernanke said on May 22 that the Fed could begin pulling back its stimulus "in a few meetings," with bond yields and interest rates broadly rising. Bernanke said that isn't a concern if rates are rising because the economy is improving.

The Fed on Wednesday said it now expects a faster decline in the 7.6% unemployment rate — to 7.2% to 7.3% by year-end and to 6.5% to 6.8% by the end of 2014. In March, the Fed expected the jobless rate to be 6.7% to 7% by the end of 2014 and to reach 6% to 6.5% at the end of 2015.

Stocks tumbled, and Treasury yields rose, during and after Bernanke's press conference.

The Dow Jones industrial average fell 206 points, or 1.4%, to 15,112, according to preliminary calculations. The broader Standard & Poor's 500 index was down 1.4% to 1,629, and the Nasdaq composite index fell 1.1% to 3,443.

The yield on the benchmark 10-year Treasury note hit a 52-week high as it jumped to 2.33%, up from 2.18% Tuesday.

The Fed's view that the unemployment rate will fall faster than prior projections theoretically could lead to an earlier increase in the Fed's benchmark short-term interest, now near zero. Fed policymakers have said they expect to keep that rate — known as the fed funds rate — at that level at least until the jobless rate falls to 6.5%, as long as the inflation outlook remains below 2.5%.

The first rate hike thus could happen as soon as 2014, rather than 2015 as previously expected. However, 14 of the 19 Fed governors and bank presidents who participate in the Fed's policy-setting meetings still don't expect the first rate increase until 2015.

Bernanke emphasized Wednesday that a short-term rate increase would depend on other labor market data as well. For example, if the unemployment rate is falling because fewer Americans are working or looking for work, it could keep its short-term rate lower longer, especially if inflation is low.

Fed policymakers do expect lower inflation. They now project inflation of 1.2% to 1.3% this year, down from their March forecast of 1.5% to 1.6%. That could give the Fed more leeway to keep its easy-money policies going longer.

The vote on the view presented in the statement was 10-2. James Bullard, the president of the St. Louis Federal Reserve Bank, dissented, saying the central bank should have signaled more strongly "its willingness to defend its inflation goal" of 2% "in light of recent low inflation readings."

Kansas City Fed Chief Esther George also dissented, saying the Fed's "easy money" policies risk financial imbalances and eventual high inflation.

Despite the Fed's more optimistic view of the jobs market going forward, it slightly lowered its forecast for economic growth in 2013. It expects GDP to grow 2.3% to 2.6% at an annual rate this year vs. its March projection of a 2.3% to 2.8% growth rate. However, the forecast for 2014 was raised to 3% to 3.5%, vs. 2.9% to 3.4% in March.

On a positive note, the Fed said "downside risks" to the economy and job market have "diminished" since last fall.

Investors grew nervous after Fed Chairman Ben Bernanke told Congress on May 22 that the central bank could begin to reduce its monthly purchases "in the next few meetings" if the job market continues to improve. His remarks chilled stocks and accelerated a bond sell-off that has seen yields on 10-year Treasuries rise about half a percentage point to 2.2% since early May.

However, many economists expect recent federal spending cuts and tax increases to slow the economy and job growth over the next few months, preventing the Fed from reining in the bond purchases as soon as September. Stocks rose Tuesday on the expectation that Fed policymakers would not ease off the stimulus, at least at this week's meeting.

Financial markets also interpreted Bernanke's testimony to mean that a tapering of the bond-buying would set off a series of events that would lead to an increase in the Fed's benchmark short-term interest rate by early 2015 — sooner than expected. Fed officials had attempted to discourage such speculation, even noting that the bond purchases could be pared and then increased again if the recovery stumbles.

In Wednesday's statement, Fed policymakers reiterated that they expect to keep the short-term near zero at until the unemployment rate, now 7.6%, falls to 6.5%, as long as the inflation rate remains below 2.5%.

The economy has been mixed lately. May retail sales and housing starts both showed solid growth but manufacturing has weakened because of the federal budget cuts and the economic downturn in Europe.

And while the labor market has held up better than expected amid the federal budget deficit-cutting, monthly job gains slowed to an average 155,000 from March through May, vs. 233,000 the previous three months. The unemployment rate last month rose to 7.6% from 7.5%.

Inflation, meanwhile, has been unusually tame, giving the Fed more leeway to maintain rock-bottom interest rates. Fed officials have said they want to avoid repeating the mistakes of past recoveries, when stimulus was cut off too early, damping growth.