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Fed likely to slow bond buys despite tepid economy

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Hiring is soft. Pay is barely up. Consumers are cautious. Economic growth has yet to pick up.

And yet on Wednesday, the Federal Reserve is expected to take its first step toward reducing the extraordinary stimulus it's supplied to help the U.S. economy rebound from its deepest crisis since the Great Depression.

If it does, the Fed will likely spark a debate: Has the economy strengthened enough to withstand the pullback?

The answer might not be clear for months.

The Fed is meeting this week at a time of deepening uncertainty about who will succeed Chairman Ben Bernanke when his term ends in January. On Sunday, Lawrence Summers, who was considered the leading candidate, withdrew from consideration.

Summers' withdrawal followed growing resistance from critics. His exit could open the door for his chief rival, Janet Yellen, the Fed's vice chair. If chosen by President Barack Obama and confirmed by the Senate, Yellen would become the first woman to lead the Fed.

For months, the Fed has said it will slow its $85 billion-a-month in Treasury and mortgage bond purchases once the outlook for the job market has improved substantially. Those purchases have been designed to keep long-term loan rates low to get people to borrow and spend and invest in the stock market.

Super-low rates are credited with helping fuel a housing comeback, support economic growth, drive stocks to record highs and restore the wealth of many Americans.

Few think the Fed will significantly reduce its bond purchases — not now, anyway. Many economists think the Fed will announce when its two-day policy meeting ends Wednesday that it will slow its purchases by $10 billion — to $75 billon a month.

The pullback is expected to come from the Fed's Treasury purchases. It will likely maintain the pace of its mortgage bond buying to try to keep home-loan rates down to sustain the housing rebound.

Some had once expected a sharper first reduction in the Fed's purchases of around $20 billion a month. But that was before the government said that job growth was only modest in August and that employers added many fewer jobs in June and July than previously thought.

So why do economists think the Fed will reduce its stimulus for the economy at all?

In part, some Fed officials don't think the bond purchases are doing much good anymore. And they feel that by continuing to flood the financial system with cash, the Fed might be raising the risks of high inflation or dangerous bubbles in assets like stocks or real estate. Just the mention of a slowdown in bond purchases spooked investors. Some fear that the Fed's ultra-low-rate policies distorted the prices of some assets.

In addition, the Fed eventually needs to sell its vast investment portfolio, which is on track to top $4 trillion next year, without upsetting markets. The more the Fed expands its portfolio, the harder and more perilous the eventual sell-off could be.

And because the Fed has been raising expectations that its pullback will start as soon as September, some Fed officials may worry that defying those expectations would rattle investors.

Finally, there's Bernanke's expected departure in January. If the Fed is going to slow its stimulus, officials may not want to wait until their last meeting of the year in December, just before a new chairman takes over. That's, in part, why some think a pullback in bond purchases will be announced Wednesday.

"Bernanke may well want to have a bond-reduction program in place before a new chairman comes in," said David Wyss, a former chief economist at Standard & Poor's and now an economics professor at Brown University.

All that said, it's possible the Fed will choose not to slow its bond purchases now. In recent public remarks, some Fed officials have sounded uncertain that the economy and the job market have improved enough.

Once the Fed announces its decisions Wednesday, it will issue updated forecasts for the economy and Bernanke will hold a news conference.

Analysts expect the Fed to downgrade its economic outlook for 2013 from its previous forecast in June. That forecast estimated that the economy would grow at a still-sluggish annual rate between 2.3 percent and 2.8 percent this year. Through the first six months of 2013, the economy has grown at a much slower 1.8 percent rate.

Many think the Fed will try to cushion the response to a pullback in long-term bond purchases by stressing it has no intention of raising short-term interest rates anytime soon. The Fed has said it expects to keep its benchmark short-term rate near zero at least until the unemployment rate falls to 6.5 percent — as long as the inflation outlook remains mild.

The unemployment rate is now 7.3 percent, the lowest since 2008. Yet the rate has dropped in large part because many people have stopped looking for work and are no longer counted as unemployed — not because hiring has accelerated. And most of the new jobs are low-paying, part-time positions. Inflation is running below the Fed's 2-percent target.

Any long-term reassurances from the Fed could face skepticism from investors who know that a new chairman might alter its policymaking. In addition, up to five new officials could join the Fed's seven-member board next year.

The Fed has struggled at times to send a clear message about its likely timetable for changing policies. Yet in recent months, the Fed and Bernanke have been explicit that a pullback in bond purchases would likely start by year's end and perhaps by September.

"This is the market's consensus view, and Fed officials are the ones who have guided the market to that consensus," said Mark Zandi, chief economist at Moody's Analytics. "At this point, the Fed doesn't want to jumble its communications."

Investors have sent long-term rates up in anticipation of a slowdown in purchases. Since Bernanke first hinted in May that a pullback was likely by year's end, the rate on the 10-year Treasury note has jumped from 1.63 percent in early May to 2.89 percent.

And long-term mortgage rates have surged more than a full percentage point since May, an increase that's made home-buying more difficult for some.

David Jones, chief economist at DMJ Advisors, foresees the Fed cutting back on its purchases at a rate of about $10 billion at each meeting between now and mid-2014.

Even by that timetable, the Fed's stock of Treasury and mortgage bonds will grow: The investment portfolio will likely near $4.5 trillion by next summer. It's now a record $3.66 trillion — a four-fold increase from its level when the financial crisis erupted five years ago.

Even after new bond buying winds down, the Fed plans to keep reinvesting its bond holdings. It just won't be adding to its stockpile. It will still be providing extraordinary support for the economy.

And yet some economists remain unconvinced that now is the time to slow the purchases.

"Interest rates have already gone up as a result of their just talking about bond reductions," said Sung Won Sohn, an economics professor at California State University's Martin Smith School of Business. "If they actually began cutting bond purchases, that would push interest rates up more and damage the economy."

Wyss thinks Bernanke's imminent departure is the main factor.

"If this were a decision based on economics, I think the Fed would wait, but given the politics of a new chairman having to go before Congress for confirmation, that could be an argument for moving now," Wyss said.

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