Fed Outlines Timeline for Winding Down Stimulus

Fed Outlines Timeline for Winding Down Stimulus

WASHINGTON — The Federal Reserve chairman, Ben S. Bernanke, said on

Wednesday that the central bank intended to reduce its monetary

stimulus later this year — and end the bond purchases entirely by the

middle of next year — if unemployment continued to decline at the pace

that the Fed expected.

Mr. Bernanke said that the Fed planned to continue the asset purchases

until the unemployment rate fell to about 7 percent, the first time

that the Fed has specified an economic objective for the bond-buying.

The rate stood at 7.6 percent in May.



The Federal Reserve also struck notes of greater optimism about the

economic recovery, saying in a statement released after a two-day

meeting of its policy-making committee that the economy was expanding

"at a moderate pace," the job market was improving and risks to the

recovery had "diminished since last fall."



In a separate forecast released at the same time, Fed officials

predicted that the unemployment rate would decline more quickly than

they had previously expected, falling to 6.5 percent to 6.8 percent by

the end of 2014. They had predicted in March that the rate would be

6.7 percent to 7 percent.



Stocks fell on Wall Street after Mr. Bernanke's remarks, with the Dow

Jones industrial average ending down 1.4 percent, or more than 200

points. The broader Standard & Poor's 500-stock index also lost 1.4

percent. Investors sold on his indications that the Fed would reduce

its stimulus efforts starting later this year.



The Fed said that it would continue for now to purchase $85 billion a

month in Treasury securities and mortgage-backed securities, in

addition to holding short-term interest rates near zero. Both policies

are intended to ease financial conditions, to encourage economic

activity and to increase the pace of job creation.



Two of the 12 members of the Federal Open Market Committee dissented

from the decision. Esther George, president of the Federal Reserve

Bank of Kansas City, reiterated her concern that the Fed was doing too

much. James Bullard, president of the Federal Reserve Bank of St.

Louis, broke with the majority for the first time this year,

expressing concern about the sagging pace of inflation.



The improved outlook helps to explain why Fed officials have

increasingly suggested that they may seek to reduce the pace of asset

purchases in the coming months. The Fed has said that it will stop

buying bonds well before it begins to raise interest rates.



While the vast majority of the 19 Fed officials who participate in

policy continue to expect a first rate increase in 2015, 13 said they

expected the Fed to raise its benchmark short-term rate at least to 1

percent by the end of 2015, implying that increases would begin

relatively early in the year. In March, only 10 officials forecast

that rates would hit 1 percent by the end of 2015.



The Fed's forecasts have consistently overestimated the strength of

the economic recovery since the end of the recession. The central bank

has suspended its stimulus efforts twice in recent years, only to find

that it needed to do more. Officials have said that they are eager to

avoid repeating those mistakes. But there is growing optimism inside

the central bank that the Fed is finally doing enough.



The Fed is trying to encourage job creation through a loose monetary

policy, holding short-term interest rates near zero and purchasing $85

billion a month in mortgage-backed securities and Treasury securities.



Economic conditions have improved modestly since the Fed began this

latest round of asset purchases last September. The economy has added

about 197,000 jobs a month, on average, and the unemployment rate has

fallen slightly to 7.6 percent in May from 7.8 percent in September.

The impact of federal spending cuts so far has been smaller than many

forecasters, including the Fed, had expected.



But the economic damage of the recession remains largely unrepaired.

Job growth is basically just keeping pace with population growth. The

share of American adults with jobs has not increased in three years.

At the same time, the Fed's preferred measure of inflation has sagged

to an annual pace 1.05 percent, the lowest level in more than 50

years, as the economy continues to operate below capacity.

Despite high unemployment and low inflation, the Fed has shown no

interest in expanding the pace of its stimulus campaign. Officials say

that they are doing as much as they can. The debate instead has

focused on how soon the Fed can afford to start buying fewer bonds.

Such a deceleration is not likely before September, at the earliest,

but officials have sought to prepare investors for the change. In

particular, the Fed wants to underscore that a smaller monthly volume

of bond purchases still means that the Fed's portfolio would be

growing larger with each passing month. Indeed, the Fed argues that

such a change would not amount to a tightening of monetary policy

because the size of the portfolio is the source of the stimulus.



The Fed's chairman, Ben S. Bernanke, also has been at pains to remind

investors that a change in the pace of bond purchases does not

indicate a change in the duration of the Fed's plans to keep

short-term rates near zero, which it has said it intends to do at

least until the unemployment rate falls below 6.5 percent.



Investors, however, have responded skeptically. After all, the Fed

needs to slow down first before it begins to retreat. Interest rates

on 10-year Treasuries, a benchmark for the Fed's efforts to reduce

borrowing costs, rose to 2.20 percent on Tuesday from a low of 1.66

percent at the start of May.



"Fed officials have been trying to convince everyone that QE is a

flexible instrument and that the onset of tapering does not convey

information about the date of the first fed funds rate hike," Vincent

Reinhart, chief United States economist at Morgan Stanley, wrote

Wednesday. "We believe such a conclusion is false."



Moreover, some economists regard the volume of monthly purchases as

more important than the total amount of the Fed's holdings, meaning

that a reduction in monthly purchases would indeed tend to tighten

financial conditions.



The Fed also finds itself warring against psychology.



The Fed has established $85 billion as a baseline in the minds of

investors. That might not matter if the benefits of the program were

purely mechanical. But buying bonds is also a way for the Fed to

signal its determination to keep interest rates low for years to come.



The program, in other words, is an effort to instill confidence in

investors. And any reduction in the pace of purchases tends to

undermine that message.

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