Fed says U.S. recovery is underway

By Mark Felsenthal and Alister Bull

WASHINGTON (Reuters) - The Federal Reserve on Wednesday upgraded its assessment of the U.S. economy, saying growth had returned after a deep recession, while reiterating its promise to hold interest rates very low for a long time.

The Fed also said it would slow its purchases of mortgage debt to extend that program's life until the end of March, in a move toward withdrawing the central bank's extraordinary support for the economy and markets during the contraction.

The U.S. central bank, as widely expected, held its benchmark overnight lending rates at close to zero percent.

"Information received since the Federal Open Market Committee met in August suggests that economic activity has picked up following its severe downturn," the Fed said in a statement after its two-day policy meeting.

"Conditions in financial markets have improved further and activity in the housing sector has increased," it said.

U.S. government bond yields ended lower on the news that the central bank had reiterated a pledge to keep rates ultra-low for an extended period.

"I think it confirms that the economy still needs a little bit of help and that rates aren't going to go up anytime soon," said Alan Lancz at Alan B. Lancz & Associates in Toledo, Ohio.

But a stock market rally fizzled on concerns the Fed was setting the stage for pulling back from its efforts to stimulate the economy. The Dow Jones industrial average ended down 81.77 points or 0.83 percent at 9,748.10.

"There's still a lot of problems with mortgages, the housing market in general as well as the banking sector," said Dan Faretta, a market strategist at Lind-Waldock, a brokerage firm, in Chicago.

The Fed said it would gradually slow the pace of its purchases of mortgage-related debt in order to promote a smooth transition in markets as the Fed has been the biggest buyer.

But it made clear it would purchase the full amount of $1.25 trillion in agency mortgage-backed securities. In its August statement the Fed had said it would buy "up to" that amount, but dropped those two words on Wednesday.

At least one member of the Fed's policy-setting committee had proposed curtailing mortgage-backed securities purchases, saying they provide too much of a boost as recovery takes off.

The Fed doubled the size of its balance sheet to more than $2 trillion as it flooded financial markets with money during the crisis last year.

Some policy-makers worry the bloated balance sheet risks triggering inflation if the Fed waits too long before removing its stimulus measures and raising interest rates.

However, the U.S. central bank on Wednesday played down concerns about price pressures in an economy where the jobless rate is at a 26-year high and factory capacity is greatly underutilized.

Policy-makers said inflation would remain subdued for some time with substantial slack in the economy dampening cost pressures, and with long-term inflation expectations stable.
In August the Fed had noted rises in energy and commodity prices, but dropped that reference this week, suggesting that worries about inflation had diminished.

The Fed has maintained its support for the economy, even after cutting interest rates to near zero, through a campaign to buy $300 billion of longer-dated U.S. government bonds and $1.45 trillion of mortgage-related debt, in order to keep lending rates low.

The Fed opted in August to taper down the U.S. Treasury debt purchases by the end of October, and had been expected to opt for a similar gradual withdrawal for its mortgage debt buying which initially had been scheduled to close at year-end.

The U.S. central bank must walk a delicate path between acknowledging the recovery evident in the economy, and assuring investors that it remains attuned to the risks of a double dip recession as policy stimulus fades next year.

This means exiting in time from aggressive steps aimed at boosting growth to avoid igniting inflation as the economy picks up steam, while not smothering the recovery in the process.

Recent data has pointed to turnarounds in manufacturing, housing markets and consumer sentiment, and many analysts expect strong growth in the third quarter after four quarters of contraction. However, with unemployment at a 26-year high of 9.7 percent, most analysts nevertheless expect consumer spending to remain weak and damp the recovery.