Fed sees hope but leaves key interest rate near zero

The Federal Reserve on Wednesday gave its most upbeat assessment of the U.S. economy in many months, while making clear that it would indefinitely keep short-term interest rates at rock bottom.

In their statement after a two-day meeting, Fed policymakers said recent data suggested that "economic activity is leveling out."

By contrast, the statement after the central bank's June meeting indicated that the Fed believed the economy was continuing to contract, though at a slower pace.

The stock market, which has surged this summer on expectations of an economic recovery, finished broadly higher for the day -- although almost all of its gains came before the Fed's midday announcement. The Dow Jones industrial average rose 120.16 points, or 1.3%, to 9,361.61.

The Fed's change in its wording, though slight, reinforced recent data on manufacturing, employment and other economic indicators that have raised hopes that the great recession was ending.

In another shift, policymakers confirmed plans to wind down their program of buying $300 billion of Treasury securities for the Fed's own account. That effort had been aimed at restraining long-term interest rates, but the central bank had been widely expected to finish the purchases this fall.

On the economy, Chairman Ben S. Bernanke and his peers said in their statement that activity was "likely to remain weak for a time" and reiterated that they planned to hold their benchmark short-term interest rate between zero and 0.25% for "an extended period."

"They're nowhere close to thinking about . . . raising rates," said Alan Levenson, chief economist at T. Rowe Price Group in Baltimore. Given the head winds the economy faces, many analysts believe the Fed won't lift rates until mid-2010 at the earliest, and perhaps not until 2011.

The Fed signaled continuing concern about the financial health of American consumers, whose spending accounts for about 70% of economic activity.

"Household spending has continued to show signs of stabilizing but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit," the Fed said.

"Their take on the economy is more upbeat -- seeing a bottoming in progress -- but still quite cautious," economists at Goldman, Sachs & Co. said in a note to clients.

On a positive note, policymakers said businesses were making progress in aligning inventories with sales.

Many companies have continued to cut back sharply on inventories in recent months, fearful that the recession might drag on. But low inventories mean many firms may soon have to ramp up production and orders to restock store shelves and warehouses.

By slashing its key short-term interest rate to as low as zero in December as the economy and financial system crumbled, the Fed was left without its principal lever to help revive growth.

Unable to cut short-term rates further, the Fed began to create programs aimed at providing credit directly to hard-hit sectors of the economy. One of those programs, launched in March, was a commitment to buy as much as $300 billion of Treasury securities for the Fed's own balance sheet. The goal was to keep a lid on Treasury bond yields as the government borrowed record sums to fund economic-stimulus programs.

But Treasury yields have risen anyway, in large part because many investors are eschewing government debt in favor of riskier assets such as stocks.

The central bank has purchased more than $250 billion of Treasuries since the program began and was on track to complete the purchases next month. In its statement, the Fed said it would slow its remaining purchases to "promote a smooth transition in markets" and would finish the program in October.

The Fed said it remained committed to its plan to buy up to $1.25 trillion of government agency mortgage-backed bonds as a way to hold down home-loan rates.

With the economy showing signs of improvement, the Fed has been forced this summer to address the question of an "exit strategy" for its lending programs, which have ballooned the central bank's balance sheet to $2 trillion.

Bond investors fear that too much of the money will eventually get into the real economy and stay there, fueling inflation. But Bernanke has insisted that, once economic growth resumes, the central bank will be able to vacuum up that money fast enough to avoid an inflation breakout.




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