Fed raises key rate and unveils plan to reduce bond holdings

The Federal Reserve has raised its key interest rate for the third time in six months, providing its latest vote of confidence in a slow-growing but durable economy. The Fed also announced plans to start gradually paring its bond holdings later this year, which could cause long-term rates to rise.

The increase in the Fed's short-term rate by a quarter-point to a still-low range of 1 percent to 1.25 percent could lead to higher borrowing costs for consumers and businesses and slightly better returns for savers. The Fed foresees one additional rate hike this year but gave no hint of when that might occur.

The overarching message the Fed sent Wednesday was an upbeat one: It believes the U.S. economy is on firm footing as it enters its ninth year of recovery from the Great Recession, with little risk of a recession. Though the economy is growing only sluggishly and though inflation remains chronically below the Fed's 2 percent target, it foresees improvement in both measures over time.

And the most important pillar of the economy — the job market — remains solid if slowing, with unemployment at a 16-year-low of 4.3 percent — even below the level the Fed associates with full employment.

The Fed's decision to raise rates, announced in a statement after its latest policy meeting, was approved 8-1, with Neel Kashkari, head of the Fed's Minneapolis regional bank, dissenting in favor of holding rates unchanged.

The announcement that the Fed plans to begin paring its balance sheet later this year — "provided that the economy evolves broadly as anticipated" — involves its enormous portfolio of Treasury and mortgage bonds. The Fed began buying the bonds after the Great Recession to try to depress long-term loan rates. That effort resulted in a five-fold increase in its portfolio to $4.5 trillion.

On Wednesday, the Fed said it would eventually allow a small amount of bonds to mature without being replaced — an amount that would gradually rise as markets adjusted to the process. This process could put upward pressure on long-term borrowing rates.

The Fed would start with monthly reductions in Treasury holdings of no more than $6 billion and $4 billion in mortgage bonds. Those figures would rise in increments over a year until they reached $30 billion a month in Treasurys and $20 billion in mortgage bonds.

"With the Fed stating its intentions to start reducing the size of the balance sheet this year, it is offering a clear vote of confidence for the economy," said Curt Long, chief economist of the National Association of Federally Insured Credit Unions.

Chair Janet Yellen was asked at a news conference whether she worried that the Fed could rattle markets once it starts shrinking its bond holdings. She said the central bank feels confident it can avoid "market strains" by detailing its plan far in advance and by stressing that the process will be gradual.

The Fed provided no date for the start of the bond sales but said that if the economy fares as expected, "we could put this into effect relatively soon."

The Fed also issued updated economic forecasts that showed it foresees one additional rate increase this year to follow Wednesday's increase and an earlier rate hike in March.

The rate forecast, based on individual projections from each member, envisions three more rate hikes in 2018 and three more in 2019. By then, the Fed's forecast would put its key policy rate at 3 percent. That's the level the Fed believes is a neutral rate — neither stimulating growth nor restraining it.

But the Fed's forecasts are only predictions and are frequently revised as its assessments evolve. Some economists suggested that even though the Fed foresees one more rate hike this year, the persistently low inflation may lead it to leave rates alone until 2018. Some also note that political paralysis in Washington has raised doubts about whether Congress will increase the nation's borrowing limit and pass a new budget. That possibility, too, could lead the Fed to wait.

Another rate hike this year is "becoming less of a sure thing as every month of data comes out," said Michael Dolega, senior economist at TD Economics. If inflation doesn't pick up, he said, the Fed will find that raising rates and reducing its balance sheet is "going to be a difficult maneuver."

The Fed's revised forecasts reduced its estimate for unemployment by year's end to 4.3 percent from a March projection of 4.5 percent. Unemployment has already reached a 16-year low of 4.3 percent.

The Fed kept forecast for economic growth this year of 2.2 percent, up slightly from its March forecast, with growth of 2.1 percent in 2018 and 1.9 percent in 2019. Those forecasts are far below the 3 percent annual growth the Trump administration has said it can achieve through tax cuts, deregulation and tougher enforcement of trade rules to protect American jobs.

The central bank updated its inflation projections to take account of a slowdown. It forecast that prices will rise just 1.6 percent this year, down from a March forecast of 1.9 percent. The Fed still foresees prices, as measured by a gauge tied to consumer spending, rising 2 percent in 2018 and 2019, achieving its target.

President Donald Trump is expected soon to fill three vacancies on the Fed's influential board, and those new members, depending on who they are, could alter its rate-setting policy.

The betting is that the administration will choose officials who will tilt the Fed toward a more "hawkish" stance. Hawks tend to worry that rates kept too low for too long could escalate inflation or fuel asset bubbles. By contrast, "doves" favor the direction taken under Yellen, favoring relatively low rates to maximize employment.

Yellen, the first woman to lead the Fed, is serving a term that will end in February. So far, Trump has sent conflicting signals about whether he plans to nominate her for a second term.

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AP Economics Writer Paul Wiseman contributed to this report.

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