Chairman Ben Bernanke has ended weeks of speculation by saying the Federal Reserve will likely slow its bond-buying program later this year and end it next year because the economy is strengthening.
The Fed’s purchases of Treasury and mortgage bonds have helped keep long-term interest rates at record lows. A pullback in its $US85 billion-a-month program would probably mean higher rates on mortgages and other consumer and business loans.
Speaking at a news conference on Wednesday after a two-day Fed meeting, Bernanke said the reductions would occur in “measured steps” and that the bond purchases could end by the middle of next year. By then, he thinks unemployment will be around 7 per cent.
The chairman likened any reduction in the Fed’s bond purchases to a driver letting up on the accelerator rather than applying the brakes. He stressed that even after the Fed ends its bond purchases, it will continue to maintain its vast investment portfolio, which will help keep long-term rates down.
The ultra-low borrowing rates the Fed has engineered have been credited with helping fuel a housing comeback, support economic growth, drive stocks to record highs and restore the wealth America lost to the recession.
Anticipating higher rates, investors reacted on Wednesday by selling both stocks and bonds. The Dow Jones industrial average closed down 206 points. The yield on the 10-year Treasury note shot up to 2.33 per cent from 2.21 per cent.
“There’s fear you’ll see an expanding economy, which has a tendency to push up interest rates,” said Jack Ablin, chief investment officer of BMO Private Bank.
Some investors worry that higher rates will cause investors to shift money out of stocks and into higher-yielding bonds. Others fear the economy might not be ready to absorb higher rates and that consumers and businesses could pull back on borrowing.
Talley Leger, a strategist at Macro Vision Research, said investors had become hooked on the Fed’s efforts to keep rates at record lows.
“Markets are asking for expansion of already stimulative policies, and they’re not getting it,” Leger said. “It’s like a drug supplier and an addict.”
After its two-day policy meeting ended on Wednesday, the Fed issued an updated economic forecast, which sketched a brighter outlook. And in a statement, it said the “downside risks to the outlook” had diminished since fall. Fed members voted to continue the pace of its bond-buying program for now.
At his news conference, Bernanke suggested that increased home prices and household wealth, a stronger construction industry and steady consumer spending would help support economic growth and offset higher mortgage rates.
“Generally speaking, financial conditions are improving,” he said.
The Fed’s more upbeat forecast helps explain why it thinks record-low rates may soon no longer be necessary. Low rates help fuel economic growth. But they also raise the risk of high inflation and dangerous bubbles in assets like stocks or real estate.
Timothy Duy, a University of Oregon economist who tracks the Fed, called its statement “an open door for scaling back asset purchases as early as September”.
The fact that the Fed foresees less downside risk to the job market “gives them a reason to pull back” on its bond purchases, Duy said.
