Fed signals end to bond buys

Federal Reserve Chairman Ben S. Bernanke outlined a path for eventually ending the central bank’s unprecedented stimulus efforts after Fed officials voiced surprising optimism about the economy.

At the end of their two-day meeting Wednesday, Fed policymakers said the latest data indicate that economic activity is expanding “at a moderate pace” and that “downside risks” for the economy and the labor market have “diminished” since last fall.

Still, the Federal Open Market Committee, in a 10-2 vote, decided for now to continue buying $85 billion worth of Treasury notes and mortgage-backed securities each month to push down mortgage and other long-term interest rates and improve broader financial conditions.

In his quarterly post-meeting news conference, Bernanke said the Fed would start to taper its securities purchases later this year and end the stimulus program in mid-2014 -- as long as the economy continues improving and the unemployment rate continues to fall at the pace expected by the nation’s central bank.

The committee also decided to keep its benchmark interest rates at or near zero at least until the nation’s unemployment rate falls to 6.5%. Last month, the rate stood at 7.6%.

For Americans, the Fed’s plans mark another sign that the recovery is on solid footing despite higher taxes and mandatory federal budget cuts this year. The plans would lead to higher mortgage and car loan rates, but also would give consumers a boost in interest rates on their savings.

Many analysts didn’t expect the Fed to be so optimistic about the economy or so willing to outline when the nation’s central bank would stop feeding money into it.

“The fuse has been lit” on the timetable for ending the stimulus, said Jim Russell, senior equity strategist at U.S. Bank Wealth Management. In addition, he said, “the economic projections that the Fed released were a bit stronger than we would have thought.”

Bernanke told reporters that the strength of the housing market, as well as the growing stability of state and local governments, have given the Fed reason for optimism.

Though improving economic conditions could lead the Fed to start reducing its bond buying, Bernanke stressed that a full pullback of the stimulus and the start of interest-rate hikes were still a long way off.

“To use the analogy of driving an automobile, any slowing in the pace of [bond] purchases will be akin to letting up a bit on the gas pedal as the car picks up speed, not to beginning to apply the brakes,” Bernanke said.

He also pointed out that even after the Fed starts tapering the stimulus, any worsening of economic conditions could warrant increased bond buying.

The markets took Bernanke’s words harshly, though there is probably little the Fed chairman could have said to push stocks higher after a weeklong run. Stocks tumbled more than 1% as investors hoped for signals the Fed would continue its current stimulus into next year.

The Dow Jones industrial average of blue-chip stocks lost 206.04 points, or nearly 1.4%, to 15,112.19. The broader Standard & Poor’s 500 index shed 22.88 points, or 1.4%, to 1,628.93, while the Nasdaq composite index fell 38.98 points, or 1.1%, to 3,443.20.

The bond market also saw a steep sell-off Wednesday, fueled by worries that bonds would lose value as the Fed scales back its purchases. The benchmark 10-year Treasury bond’s yield jumped to 2.35%, its highest level in nearly 15 months, from 2.19% Tuesday.

But many observers, including Jay Wong, principal of the Payden Equity Income Fund in Los Angeles, shrugged off the market sell-off as a “little extreme.”

“It’s not a bad thing that the economy is actually recovering and the Fed doesn’t need to support it as much anymore,” Wong said. “That’s good news -- for the equity market, at least.”

And Jack Ablin, chief investment officer for BMO Private Bank in Chicago, noted: “Once equity investors go home and take a deep breath, this is probably a net positive for them.”

Reflecting their optimism, Fed officials upgraded some key economic projections. Most important, they forecast that the unemployment rate could drop to as low as 7.2% this year and 6.5% in 2014. It was at 7.6% in May and 8.1% when the bond-buying program began in September.

Some analysts were skeptical about the projections. Though the housing market has been improving, the private sector isn’t adding jobs as quickly as many had hoped, and unemployment remains elevated.

“I’m surprised that they put so much weight on their forecasts,” said Michael Gapen, director of U.S. economic research at Barclays. “I agree that the outlook looks better, I’d just think they’d want to see more evidence that the private sector was accelerating.”

In his news conference, Bernanke emphasized that if the Fed’s forecasts were wrong, it would adjust its policies accordingly.

“Our policies are going to depend on this scenario coming true,” he said. “If it doesn’t come true, we’ll adjust our policies to that.”

In their statement Wednesday, Fed policymakers found that inflation so far is staying below the central bank’s target of 2%, and they projected it would stay at or below that level over the medium term.

Financial markets are skittish about when and how the Fed will start reducing its stimulus because its actions could cause interest rates to rise and make stocks less-attractive investments.

Recent comments by Bernanke and other Fed officials have indicated that an exit could be coming soon, and that has fueled a jump in long-term interest rates, which, in turn, has caused mortgage rates to rise from their record lows.

Bernanke reiterated that the Fed wouldn’t even consider starting to raise the rock-bottom short-term interest rates until unemployment got to 6.5%. But he acknowledged the difficulty Fed officials have in ending their stimulus programs, likening it to smoothly landing on an aircraft carrier.

There has been some speculation this week about whether Bernanke will be the person to bring the stimulus programs to an end, after President Obama said in an interview that the chairman had stayed in the position longer than he wanted to.

Bernanke would not comment about his future at the news conference.

Analysts said that whoever is in the chairman’s seat will have to toe a fine line going forward, assuring analysts that the economy is improving while being transparent about its stimulus programs.

“They are close to tapering, but at the same time, that doesn’t mean they’re ready to start shrinking the balance sheet,” Gapen said. “It’s a tough communication line to walk.”

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jim.puzzanghera@latimes.com alana.semuels@latimes.com andrew.tangel@latimes.com

Puzzanghera reported from Washington; Semuels and Tangel from New York.