ANALYSIS: Improving US Economy Leads Fed to Ease Stimulus

The Federal Reserve has sent its strongest signal of confidence in the U.S. economy since the Great Recession struck six years ago: It’s decided the economy is finally strong enough to withstand a slight pullback in the Fed’s stimulus.

Yet the Fed also made clear it’s hardly withdrawing its support for an economy that remains below full health. Chairman Ben Bernanke stressed that the Fed will still work to keep borrowing rates low to try to spur spending and growth and increase very low inflation.

At his final news conference as chairman before he leaves in January, Bernanke managed a delicate balance: He announced a long-awaited and long-feared pullback in the Fed’s stimulus, yet he did so while convincing investors that the Fed will continue to bolster the economy indefinitely. Wall Street roared its approval.

In a statement after its policy meeting ended Wednesday, the Fed said that it will trim its $85 billion a month in bond purchases by $10 billion, starting in January. Bernanke said the Fed expects to make “similar moderate” cuts in its purchases if economic gains continue.

At the same time, the Fed strengthened its commitment to record-low short-term rates. It said for the first time that it plans to hold its key short-term rate near zero “well past” the time unemployment falls below 6.5 percent. Unemployment is now 7 percent.

The Fed’s bond purchases have been intended to drive down long-term borrowing rates by increasing demand for the bonds. The prospect of a lower pace of purchases could mean higher loan rates over time.

Nevertheless, investors seemed elated by the Fed’s finding that the economy has steadily strengthened, by its firm commitment to low short-term rates and by the fact that it’s only paring its bond purchases by a slight amount.

The Dow Jones Industrial Average soared nearly 300 points. Bond prices fluctuated, but by late afternoon, the yield on the 10-year Treasury note had barely moved. It inched up to 2.89 percent from 2.88 percent.

“We’re really at a point where we’re getting to the self-sustaining recovery that the Fed has been talking about,” said Scott Anderson, chief economist of Bank of the West. “It really seems like that’s going to come together in 2014.”

The Fed’s move “eliminates the uncertainty as to whether or when the Fed will taper, and will give markets the opportunity to focus on what really matters, which is the economic outlook,” said Roberto Perli, a former Fed economist who is now head of monetary-policy research at Cornerstone Macro.

Perli noted that the Fed will still buy bonds every month to keep long-term rates down and remains strongly committed to low short-term rates. By keeping rates historically low, the Fed “will continue to remain very supportive of risky assets” such as stocks, Perli said.

The stock market has enjoyed a spectacular 2013, fueled in part by the Fed’s low-rate policies. Those rates have led many investors to shift money out of low-yielding bonds and into stocks, thereby driving up stock prices. Still, the gains have been unevenly distributed: About 80 percent of stock-market wealth is held by the richest 10 percent of Americans.

Critics have argued that by keeping rates so low for so long, the Fed has heightened the risk of inflating bubbles in assets such as stocks or real estate that could burst with devastating effect. Bernanke has said the Fed remains watchful of such risks.

But he has argued that still-high unemployment and ultra-low inflation justify continued Fed stimulus.

Bernanke will step down from the Fed on Jan. 31 and be succeeded by Vice Chair Janet Yellen, whose nomination the Senate is expected to confirm as soon as this week. Asked at his news conference about Yellen’s role in the decision the Fed announced, Bernanke replied, “I have always consulted closely with Janet, even well before she was named by the president, and I consulted closely with her on these decisions, as well, and she fully supports what we did today.”

In updated economic forecasts issued Wednesday, the Fed predicted that unemployment would fall a bit further over the next two years than it thought in September. It now expects the unemployment rate to dip as low as 6.3 percent next year and 5.8 percent in 2015.

Yet the Fed expects inflation to remain below its target level. Policymakers predict that their preferred inflation index won’t reach its target of 2 percent until the end of 2015 at the earliest. For the 12 months ending in October, the inflation index is up just 0.7 percent.

The Fed worries about very low inflation because it can lead people and businesses to delay purchases. Extremely low inflation also makes it costlier to repay loans.

In its statement, the Fed said it will reduce its monthly purchases of mortgage and Treasury bonds each by $5 billion. Beginning in January, it will buy $35 billion in mortgage bonds each month and $40 billion in Treasurys.

The Fed’s low-rate policies have been duplicated by other central banks, from the European Central Bank to the Bank of Japan, that have also sought to energize economic growth and boost inflation.

The Fed’s actions Wednesday were approved 9-1. The only member to object was Eric Rosengren, president of the Federal Reserve Bank of Boston. He called the move premature because unemployment remains high and inflation extremely low.

The Fed’s action comes after encouraging reports that show the economy is accelerating. Hiring has been robust for four straight months. Unemployment is at a five-year low of 7 percent. Factory output is up. Consumers are spending more at retailers. Auto sales haven’t been better since the recession ended 4½ years ago. The stock market is at all-time highs.

And Congress gave final approval Wednesday to legislation that reduces federal spending cuts and averts the risk of another government shutdown early next year.

“It eases a bit of the fiscal restraint in the next couple of years, a period where the economy needs help to finish the recovery,” Bernanke said of the congressional deal. “So those things, you know, are positive things.”

All of which could enhance the confidence of individuals, businesses and investors.

The economy is improving consistently, and the Fed is “now recognizing the trend and decided to go with the flow,” said John Silvia, chief economist at Wells Fargo.