WASHINGTON -- In a move that could send interest rates higher, Fed Chairman Ben Bernanke ended weeks of speculation Wednesday by saying the Federal Reserve will likely slow its bond-buying program 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 extraordinary $85 billion-a-month program would likely mean higher rates on mortgages and other consumer and business loans.
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Anticipating higher rates, investors reacted Wednesday by selling both stocks and bonds. The Dow Jones industrial average closed down 206 points. The yield on the 10-year Treasury note rose to 2.35 percent. In early May, it was 1.63 percent.
Investors have been selling bonds and driving up yields since last month after vague signals from the Fed that higher long-term rates might be coming.
After a two-day policy meeting, the Fed upgraded its outlook for unemployment and economic growth. In a statement, the Fed said the "downside risks to the outlook" had diminished since fall. Fed members voted to continue the pace of the bond-buying program for now.
At a news conference afterward, Bernanke said the Fed would slow its bond buying later this year as long as the economy sustained its improvement.
He said the pullback in purchases would occur in "measured steps" and could end by the middle of 2014. By then, he thinks unemployment will be around 7 percent.
Asked why the Fed's statement made no mention of scaling back the bond purchases, Bernanke said he had been "deputized" to clarify the Fed's policy and how it might vary depending on the economy's health.
He likened any reduction in the Fed's bond purchases to a driver letting up on a gas pedal 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. Investors now think the days of record-low rates are over.
"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 drug supplier and an addict."
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.
In its statement, the Fed also said it would maintain its plan to keep short-term rates at record lows at least until unemployment reaches 6.5 percent.
In its updated economic forecast, Fed officials predicted that unemployment will fall to 7.2 percent or 7.3 percent at the end of this year from 7.6 percent now. They think the rate will be between 6.5 percent and 6.8 percent by the end of 2014, better than its previous projection in March of 6.7 percent to 7 percent.
The Fed also said inflation was running below its 2 percent long-run objective, but noted that temporary factors were partly the reason. It said inflation could run as low as 0.8 percent this year. But it predicts it will pick up next year to between 1.4 percent and 2 percent.
David Robin, co-head of the futures and options desk at the brokerage Newedge, said he didn't think Bernanke's upbeat assessment matches an economy that's just "muddling along."
Investors may suspect the Fed is looking for a reason to scale back the bond purchases, Robin said. "It's a big mess," he said.
The statement was approved on a 10-2 vote. James Bullard, the president of the Federal Reserve Bank of St. Louis, objected for the first time this year, saying he wanted a stronger commitment from the Fed to keep inflation from falling too low.
Esther George objected for the fourth time this year, again voicing concerns about inflation rising too quickly.
At his news conference, Bernanke declined to address speculation that he will step down as Fed chairman when his term ends in January.
He was asked to respond to comments Monday by President Barack Obama, who said Bernanke had already stayed longer than planned. The president's remarks added to expectations that Bernanke intends to step down.
Bernanke avoided the question.
"I would like to keep the discussion on monetary policy," he said. "I don't have anything for you on my personal plans."
David Jones, chief economist at DMJ Advisors, suggested that Bernanke had achieved a key goal Wednesday: Clearing up the confusion he'd created when he sent a mixed message to Congress last month about when the Fed might start to slow its bond buying program.
"What Bernanke did was clarify" when it will taper its bond purchases, Jones said.