MercoPress. South Atlantic News Agency

Fed decides to keep stimulus: fears of economy sluggishness and still slow labour market

Bernanke waiting for more evidence that progress will be sustained before adjusting the pace of its bonds’ purchases

In a surprise move after a two-day meeting the US Federal Reserve said on Wednesday that it would continue buying bonds at a rate of 85 billion dollars monthly and expressed concern that a sharp rise in borrowing costs in recent months could weigh on the economy.

Most market analysts were expecting the Fed to begin tapering down its huge stimulus program, but Fed chairman Ben Bernanke said in a news conference “there is no fixed calendar schedule. I really have to emphasize that; if the data confirm our basic outlook, if we gain more confidence in that outlook ... then we could move later this year”.

Stocks rallied on the U.S. central bank's decision, with the S&P 500 index hitting a record high. The dollar fell to a seven-month low against the euro, while prices for U.S. government bonds rose sharply. The price of gold, a traditional inflation hedge, also shot higher.

“The Federal Reserve remains quite concerned about the overall sluggishness of the economy, preferring to take the risk of being too loose for too long as opposed to tighten prematurely,” said Mohamed El-Erian, co-chief investment officer at Pimco, which manages the world's largest mutual fund.

In fresh quarterly projections, the Fed cut its forecast for 2013 economic growth to a 2% to 2.3% range from a June estimate of 2.3% to 2.6%. The downgrade for next year was even sharper.

It cited strains in the economy from tight fiscal policy and higher mortgage rates as it explained why it decided to maintain asset purchases at the current pace.

“The tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labour market,” it said in the statement.

The Federal Open Market Committee statement said that in July data suggested that economic activity had been expanding at a moderate pace and despite some indicators of labour market conditions showing further improvement in recent months, the unemployment rate remains elevated.

Likewise household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen further and fiscal policy is restraining economic growth. Apart from fluctuations due to changes in energy prices, inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable.

The FOMC sees the downside risks to the outlook for the economy and the labour market as having diminished, on net, since last fall, but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labour market. Furthermore inflation persistently below its 2% objective could pose risks to economic performance, but it is anticipated that inflation will move back toward its objective over the medium term.

Taking into account the extent of federal fiscal retrenchment, the Committee sees the improvement in economic activity and labour market conditions since it began its asset purchase program a year ago as consistent with growing underlying strength in the broader economy. However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of 40 billion per month and longer-term Treasury securities at a pace of 45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.

Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee's dual mandate.

In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee's expectation of ongoing improvement in labour market conditions and inflation moving back toward its longer-run objective.

“Asset purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on the Committee's economic outlook as well as its assessment of the likely efficacy and costs of such purchases”. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2%.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Charles L. Evans; Jerome H. Powell; Eric S. Rosengren; Jeremy C. Stein; Daniel K. Tarullo; and Janet L. Yellen. Voting against the action was Esther L. George, who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations.