FILE - In this July 16, 2014 file photo, Federal Reserve Chair Janet Yellen gestures as she testifies before the House Financial Services Committee hearing entitled: "Monetary Policy and the State of the Economy," on Capitol Hill in Washington. Federal Reserve policymakers begin a two-day meeting to set interest rates on Tuesday, July 29, 2014. (AP Photo/Pablo Martinez Monsivais, File)The Associated Press
WASHINGTON – This much is clear: The Federal Reserve will make another cut this week in its monthly bond purchases, which have been aimed at keeping long-term loan rates low.
This much is not: When will the Fed start tightening its interest-rate policy to thwart any runaway inflation? How will it do so? And when will the Fed start paring its enormous $4 trillion-plus investment portfolio — a step that will put upward pressure on interest rates?
On those questions, expect no definitive signals Wednesday, when the Fed issues a statement after a two-day policy meeting. In many ways, the improving U.S. economy no longer needs so much help from the central bank: Hiring is solid, and unemployment is on the cusp of a nearly normal 6 percent rate. Manufacturing is strengthening. Consumers are voicing renewed confidence.
Yet in other ways the economy the Fed will assess this week is less than fully healthy. The housing rebound appears to be faltering. Workers' pay remains flat. Turmoil overseas poses a potential threat. And even the sinking unemployment rate isn't as encouraging as it seems: It's dropped in part because many people have given up on their job searches or retired early. The government doesn't count people as unemployed unless they're actively seeking work.
Accordingly, the Fed is expected to reaffirm its plan to leave its key short-term rate at a record low near zero "for a considerable time" after it ends its bond purchases.
"The economy is doing a little bit better, but there are still a lot of risks out there," said David Wyss, an economics professor at Brown University, noting global turmoil from Ukraine to the Middle East.
The statement the Fed will release will almost surely announce a sixth $10 billion cut in its monthly bond purchases to $25 billion. Chair Janet Yellen told Congress this month that the Fed intends to end its new purchases by October. By then, its investment portfolio will be nearing $4.5 trillion — five times its size before the financial crisis erupted in September 2008.
After the crisis struck, the Fed embarked on bond purchases to try to drive down long-term rates and help the economy recover from the Great Recession. Even after its new bond purchases end, the Fed has said it will maintain its existing holdings, which means it will continue to put downward pressure on rates.
The Fed has kept its target for short-term rates near zero since December 2008. Most economists think it will start raising rates by mid-2015, though some caution that the Fed could do so sooner if the economy keeps generating jobs at a robust pace — five straight months of 200,000-plus increases.
Still, in testifying to Congress, Yellen stressed that at 6.1 percent, the unemployment rate still exceeds the Fed's target of 5.2 percent to 5.5 percent. And she noted that high levels of long-term unemployment and weak wage growth are still a problem.
Mark Zandi, chief economist at Moody's Analytics, said chronically lagging pay growth, in particular, will stop the Fed from raising rates before 2015. By then, Zandi said, "the unemployment rate will be well below 6 percent, the amount of slack in the labor market will be winding down and we should start to see better wage growth."
Yellen attributed the struggling housing rebound in part to last year's rise in mortgage rates, which occurred after the Fed chairman at the time, Ben Bernanke, began discussing possible cuts in bond purchases later in the year. Investors were jolted by the prospect of reducing the purchases — a step the Fed didn't take until December — and sent long-term bond rates up.
"The Fed really wants to be careful and tread cautiously this time," said Diane Swonk, chief economist at Mesirow Financial.
Many think the Fed will first signal an impending rate hike by modifying the phrasing it's used at each meeting this year: That it plans to keep short-term rates at record lows "for a considerable time" after its bond buying ends.
Vincent Reinhart, chief economist at Morgan Stanley and a former top Fed economist, recalled the last time the Fed started raising rates — in 2004 — after a prolonged period of low rates. Back then, he noted, the Fed said it planned to keep rates low for a "considerable period." It modified that wording six months before its next rate increase by saying it would be "patient in removing policy accommodation."
Many analysts expect a similar word change before any rate increase this time.
Besides discussing short-term rates, Fed officials this week will likely debate how to unwind their investment holdings. They face a delicate task in shrinking the portfolio to more normal levels without destabilizing markets. The Fed's bond purchases allowed it to inject money into the financial system, which wound up as reserves held by banks and helped keep loan rates low.
To reverse that process and raise borrowing rates, the Fed is considering a variety of tools. One would be to increase the interest it pays banks on excess reserves they keep at the Fed.
David Jones, author of a new book on the central bank's 100 year history, said any new exit details might not be revealed until the Fed releases the minutes of this week's meeting in three weeks.
Those minutes, Jones said, "may be the most interesting thing to come out of the meeting."