Fed, More Optimistic About Economy, Maintains Bond-Buying

WASHINGTON — Federal Reserve policy makers, more confident about the economic recovery, on Wednesday maintained their current pace of monetary stimulus.

Fed officials also predicted in their latest economic forecast, released Wednesday, that the unemployment rate will decline more quickly than they had previously expected, sitting between 6.5 percent and 6.8 percent at the end of 2014. They had predicted in March that the rate would sit between 6.7 percent and 7 percent.

Officials predicted that the annual pace of inflation would rebound next year, rising closer to the 2 percent rate that the Fed considers healthy.

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 very loose monetary policy, holding short-term interest rates near zero and by 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 sign of 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.

Article source: http://www.nytimes.com/2013/06/20/business/economy/fed-more-optimistic-about-economy-maintains-bond-buying.html?partner=rss&emc=rss