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Tuesday September 1st, 2015 4:20PM

Fed sparks a debate: When to reduce stimulus?

By The Associated Press
WASHINGTON (AP) -- The Federal Reserve's decision to postpone any pullback in its economic stimulus immediately ignited a debate: Was the Fed right or wrong to delay the inevitable?

Investors had anticipated a small cut in the Fed's $85 billion in monthly bond purchases, which are intended to keep long-term borrowing rates low to encourage spending. A pullback would have signaled that the Fed felt the economy had shown steady improvement.

Was the Fed right to hold off? Here's the case for slowing the purchases - and the case against it.

- THE CASE FOR SLOWING BOND PURCHASES:

If not now, when? That's what many economists were asking.

By not reducing its purchases as most investors and economists had expected, the Fed has heightened uncertainty about its future actions.

Back in June, it had all seemed clear: Chairman Ben Bernanke said the Fed planned to slow its purchases by year's end as long as the economy improved. The Fed's policymaking board reaffirmed that time frame at its July meeting. Borrowing rates rose in expectation that a pullback was near, with most economists forecasting that it would start in September.

Now, it isn't even clear that any pullback will begin before next year. If the Fed thinks the economy hasn't improved enough yet, there's little reason to think its view will change soon. The Fed's own forecasts foresee scant improvement until 2014.

Markets soared Wednesday in response to the Fed's decision. By maintaining the pace of its bond buying, the Fed will aim to keep borrowing rates as low as possible. That's seen as a recipe for higher bond and stock prices.

But "we wonder whether the longer-lasting reaction will be increased volatility ... as the Fed's communications become even more confused," says Paul Ashworth, an economist at Capital Economics.

So what's changed since June?

Not much. Employers have added an average of 180,000 jobs a month this year, about the same as last year and in 2011. From April through June, the economy grew at a 2.5 percent annual rate, little changed from its 2.8 percent rate in the quarter when the Fed began its bond buying.

Growth and hiring remain modest by the standards of a robust economic recovery. But they've been pretty consistent for the past few years.

The Fed's efforts, meanwhile, are more appropriate for a recession or other economic emergency, some economists argue.

"The Fed has gone to great lengths to describe its (bond purchases) as extraordinary economic stimulus," says Mark Vitner, an economist at Wells Fargo Securities. "It's not something you use when the economy is just struggling."

The Fed's decision to delay also suggests it's dismissive of concerns that its policies might be inflating dangerous bubbles in assets like stocks or real estate in the United States or overseas. By keeping mortgage rates low, the Fed has sought to accelerate the housing recovery. It's also tried to drive up stock prices. Yet the longer it continues to do so, the greater the risk that it will go too far.

Vitner notes that home prices have jumped 12 percent in the past year even as the number of homeowners has declined. And stock indexes closed at record highs Wednesday. Home and stock prices may have risen too far too fast considering the state of the economy.

The Fed's policies may have made the housing recovery appear stronger than it is: Much of the increase in sales and prices has been fueled by investors. First-time home buyers, who typically play a vital role in driving housing recoveries, remain largely on the sidelines. They face tighter credit standards, which the Fed's policies haven't addressed.

The Fed's "massive intervention ... has distorted the price of many financial instruments," said Sun Wong Sohn, an economist at California State University, Channel Islands. "The sooner (the Fed) can allow market forces dictate the price, the better."

THE CASE AGAINST SLOWING BOND BUYING

What's the hurry?

Many argue that the Fed had good reason to delay any reduction in its bond-buying program: The economy still needs the help. Economic growth and hiring remain weak. The unemployment rate remains high.

The Fed's bond purchases tend to push interest rates down, making it cheaper for consumers to buy cars and houses. Lower rates also help drive the stock market up and make Americans feel wealthier and more willing to spend. That's important in a country where consumer spending accounts for 70 percent of economic activity.

The Fed downgraded its outlook for U.S. economic growth this year and next. The job market doesn't look as strong as in the spring when the Fed raised the prospect of scaling back the bond purchases. Job growth has slowed to an average of 155,000 a month since April, down from an average 205,000 in the first four months of the year.

True, the unemployment rate has sunk to a 4 1/2-year low of 7.3 percent. But it's fallen for the wrong reason. More people have stopped working or looking for work. Once people without a job stop looking for one, they're no longer counted as unemployed.

Their departure shrank the so-called labor force participation rate - the percentage of adults who have jobs or are seeking one - to 63.2 percent, the lowest since August 1978. If those who left the labor force last month had still been looking for work, the unemployment rate would have risen to 7.5 percent in August.

Diane Swonk, chief economist at Mesirow Financial, noted that the Fed wants to see unemployment decline "because employment improves, not because the number of people looking for work falls."

The Fed has plenty of other reasons to delay any reduction in the bond purchases.

For one thing, inflation is under control. Those who want to see the Fed reduce its economic stimulus worry that super-low rates and aggressive bond purchases could ignite inflation and perhaps create dangerous asset bubbles.

But there's no inflation threat in sight. Inflation is running well below the Fed's 2 percent target. Consumer prices have risen just 1.5 percent over the past year. And there's little sign that that inflation is gaining any momentum. The Fed predicted Wednesday that inflation would stay at or below 2 percent through 2016.

A destructive budget fight also looms in Washington. Unless Congress agrees to fund the government past Oct. 1, the government will shut down. Worse, the government will reach its borrowing limit next month. If Congress won't raise the limit, the government won't be able to pay all its bills. The risk of a shutdown or default would likely rattle financial markets and could scare businesses and consumers into spending less.

The Fed doesn't want to reduce economic aid until it's sure the politicians don't wreck the economy. The upcoming budget battles "gave them the reason to hold off on tapering right now," says Greg McBride, senior financial analyst at Bankrate.com

Investors are also nervous about any reduction in Fed stimulus, despite Bernanke's assurances that even reduced bond purchases would still pump significant cash into the economy and financial markets.

Investors dumped bonds and drove up interest rates after the Fed started talking in May about cutting bond purchases. Since then, long-term mortgage rates have risen a full percentage point to the highest level in two years. Those rates could rise further if the Fed slowed its bond purchases.

David Robin, an interest rate strategist at Newedge LLC, said Fed policymakers were surprised by how quickly interest rates rose. They worried that rates would rise even more, and jeopardize economic growth, if they actually reduced the bond-buying.

"The Fed knows once they started to move," the market reaction "would be almost impossible to control," Robin said.
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