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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