Fed faces tough call on bond buying as US economy strengthens

The Federal Reserve will decide on Wednesday whether the US economy is finally resilient enough to withstand less policy support, or whether it is prudent to wait a bit longer.

With the world’s financial markets on edge, the U.S. central bank wraps up a two-day meeting with a highly anticipated policy announcement at 2 p.m. (1900 GMT), followed by Ben Bernanke’s last news conference as Fed chairman a half hour later.

Recent growth in jobs and retail sales, as well as a fresh budget deal in Congress, has convinced a growing number of economists the time is right for the Fed to trim its $85 billion in monthly bond purchases. The 15-month-old program is meant to put downward pressure on long-term borrowing costs in order to stimulate investment and hiring.

[caption id=“attachment_1241137” align=“alignleft” width=“380”]  If it waits, the Fed might still decide to better telegraph how it plans to wind down the stimulus program, as a handful of its 18 policymakers have suggested in recent weeks.[/caption]

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But many observers believe the central bank will wait until early in the new year, given persistently low inflation and the fact that the world’s largest economy has stumbled several times in its crawl out of the 2007-2009 recession.

“It is increasingly looking like a coin flip,” said Michael Feroli, JPMorgan’s chief U.S. economist.

If it waits, the Fed might still decide to better telegraph how it plans to wind down the stimulus program, as a handful of its 18 policymakers have suggested in recent weeks.

The Fed has kept interest rates near zero since 2008 and plans to leave them there for a while longer irrespective of when it begins to taper the bond buying. The purchases have swelled its balance sheet to a record $3.9 trillion.

The unprecedented money-printing has helped drive U.S. stocks to record highs and sparked sharp gyrations in foreign currencies, including a drop in emerging markets this year as investors anticipated an end to the easing. There has also been some anxiety in the United States that it could fuel inflation and hard-to-detect asset price bubbles.

Fed officials will also update their economic forecasts on Wednesday, likely acknowledging the faster-than-expected drop in joblessness to a five-year low of 7 percent last month. Perhaps most critically for investors, they could also tinker with their longer-term policy promises.

MESSAGE TO MARKETS

As it stands, officials have said the Fed will continue buying bonds until there is a substantial and sustainable pick-up in the labor market. They also want to see inflation rise somewhat from its current level of near 1 percent.

Bernanke will likely double down on his message that interest rates will stay near zero at least until unemployment falls to 6.5 percent, as long as inflation does not threaten to top 2.5 percent.

The Fed could even lower that 6.5 percent jobless rate threshold, or add a third marker that promises low rates if inflation remains below 1.5 percent – moves that would be more likely if it decides to reduce its bond buying.

The fear is that a cut to the Treasury and mortgage-bond purchases - even if only by around $10 billion per month - will lead to a market selloff that will hike mortgage rates and other borrowing costs, choking the economy’s recovery. Many borrowing costs, including for mortgages, are pegged to the yield on the 10-year Treasury note, which moves inversely to its price.

Accompanying any reduction with steps that offer reassurance that the Fed is not withdrawing its monetary support for the economy could help temper the market reaction.

“It’s clear they’d like to see these asset purchases scaled back,” said Jerry Webman, chief economist at OppenheimerFunds in New York. “It’s also clear they’re going to … do what’s necessary with monetary policy to support the economy.”

According to a Reuters poll taken before lawmakers struck a budget deal last week, only 12 of 60 economists expected the Fed to scale back its purchases this week. Twenty-two predicted it would wait until January, while about half pointed to March.

With inflation so low, “a tightening move would be quite unusual by historical standards,” Goldman Sachs economist David Mericle wrote in a client note. He expects the Fed to hold off until March.

Fed officials “will be reluctant to deliver a hawkish surprise that could tighten financial conditions and raise doubts about their commitment to the inflation target” of 2 percent, he added. The government said on Tuesday that consumer prices rose just 1.2 percent over the last 12 months.

The Fed policy meeting will be the penultimate one of Bernanke’s tenure. His second four-year term as chairman of the central bank expires on January 31, just two days after the close of the Fed’s first policy meeting of 2014.

Janet Yellen, the Fed’s vice chair and a strong proponent of the Fed’s aggressive policy response to the recession, is positioned to succeed Bernanke. The U.S. Senate is expected to vote to confirm her for the post on Thursday.

Reuters