Federal Reserve stands by aggressive stimulus but says the US economy has strengthened

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Specialists Christopher Gildea, left, and Joseph Dreyer confer on the floor of the New York Stock Exchange Wednesday, March 20, 2013. In a statement after a two-day meeting, the Fed stood by its plan to keep short-term rates at record lows at least until unemployment falls to 6.5 percent, as long as the inflation outlook remains mild. (AP Photo/Richard Drew)

WASHINGTON - The Federal Reserve said Wednesday that the U.S. economy has strengthened but still needs the Fed's extraordinary support to help lower high unemployment.

In a statement after a two-day meeting, the Fed stood by its plan to keep short-term interest rates at record lows at least until unemployment falls to 6.5 per cent, as long as the inflation outlook remains mild. And it said it would continue buying $85 billion a month in bonds indefinitely to keep long-term borrowing costs down.

Speaking at a news conference, Chairman Ben Bernanke stressed that while the economy has improved, the Fed won't ease its aggressive stimulus policies until it's convinced the economic gains can be sustained. An unemployment rate of 6.5 per cent is a threshold, not a "trigger," for a possible rate increase, he said.

Bernanke also said the Fed might vary the size of its monthly bond purchases depending on whether or how much the job market improves. The unemployment rate has fallen to a four-year low of 7.7 per cent, among many signs of a healthier economy.

"We are seeing improvement," Bernanke said. "One thing we would need is to see this is not temporary improvement."

Jim O'Sullivan, chief U.S. economist at High Frequency Economics, said the Fed appears focused on "whether recent improvement continues, and no changes to the (bond) purchase program appear imminent."

But O'Sullivan said he thinks the Fed might scale back its bond purchases in the second half of this year if job growth continues to accelerate.

Brian Bethune, an economics professor at Gordon College in Wenham, Mass., said the Fed's first move might be to reduce its monthly bond purchases in the October-December quarter of this year and again in the first quarter of 2014. Reducing the Fed's bond purchases would likely cause interest rates to rise, making loans more expensive, and possibly cause stock prices to fall.

But investors seemed pleased with the Fed's decision to maintain its low-interest rate policies indefinitely for now. The Dow Jones industrial average close up about 56 points, having risen slightly after the Fed's statement was released at 2 p.m. EDT.

The Fed's statement took note of the global stresses that have been intensified by the turmoil in Cyprus, which is trying to stave off financial ruin. No longer does the Fed statement say, as it did in December, that "strains in global financial markets have eased somewhat."

Bernanke was asked at his news conference whether the flare-up in Cyprus signals that the U.S. financial system might be more vulnerable than bank "stress tests" have shown. He sought to downplay the dangers posed by the tiny Mediterranean nation. Bernanke said that "at this point," he sees no major risks to the U.S. financial system or economy.

The Fed noted in its statement that the U.S. job market has improved, consumer spending and business investment have increased and the housing market has strengthened. But its latest economic forecasts, also released Wednesday, show that the Fed still doesn't expect unemployment to reach 6.5 per cent until 2015.

The Fed also cautioned that government spending cuts and tax increases could slow the economy. It predicts that growth won't exceed 2.8 per cent this year, slightly lower than its December forecast of 3 per cent.

A total of 13 Fed officials still think the first rate increase won't occur until 2015, the same number that thought so in December. One Fed official thinks the first boost in the short-term lending rate won't occur until 2016.

The statement was approved on an 11-1 vote. Esther George, president of the Kansas City regional Fed bank, dissented for a second straight meeting. She reiterated her concerns that the Fed's aggressive stimulus could heighten the risk of inflation and financial instability — a concern shared by other critics.

Some economists say they fear the Fed has pumped so much money into the financial system that it could eventually ignite inflation, fuel speculative asset bubbles or destabilize markets once the Fed has to start raising rates or unloading its record $3 trillion investment portfolio.

And while the Fed's low interest-rate policies are intended to boost borrowing, spending and stock prices, they also hurt millions of retirees and others who depend on income from savings.

"Things are not going to get better for savers," said Greg McBride, senior financial analyst at Bankrate.com. "Rates are going to stay low for borrowers, and the Fed's accommodation will continue to be a positive for the stock market. Right now, the market is addicted to Fed stimulus."

The economy slowed to an annual growth rate of just 0.1 per cent in the October-December quarter, a near-stall that was due mainly to temporary factors that have largely faded. Economists think growth has rebounded in the January-March quarter to an annual rate around 2 per cent or more. The most recent data support that view.

Americans spent more at retailers in February despite higher Social Security taxes that shrank most workers' paychecks. Manufacturing gained solidly in February. And employers have gone on a four-month hiring spree, adding an average of 205,000 jobs a month. In February, the unemployment rate, though still high, reached its lowest point since December 2008.

One reason for the Fed's reluctance to reduce its stimulus is the history of the past three years. In each of the three, economic prospects looked promising as the year began. Yet in each case, the economy stumbled.

Though the economy has brightened this year, it still faces threats, including across-the-board government spending cuts that took effect March 1 and are expected to trigger furloughs and layoffs.

The Fed's forecasts for the economy are rosier than those issued by the Congressional Budget Office. The CBO has warned that the government spending cuts, along with the Social Security tax increase and higher taxes on top earners, could slow growth by 1.5 percentage points this year, to 1.5 per cent.

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AP Economics Writer Christopher S. Rugaber contributed to this report.