Fed to keep buying bonds, but may point to plans to taper

By Alister Bull

WASHINGTON (Reuters) - The U.S. Federal Reserve likely will decide at the end of a policy meeting on Wednesday to continue buying bonds at an $85 billion monthly pace, but it could alter an accompanying statement to spell out the possibility of scaling back purchases later this year.

Even if it does, the Fed is unlikely to clarify whether that process will begin in September, as financial markets expect, or later. Fed officials would prefer to see more evidence that the recovery in the job market is first fully entrenched.

The 19 members of the U.S. central bank's policy-setting committee will conclude a regular two-day gathering with a statement at 2 p.m. (1800 GMT).

"I expect that sentiment (of leaning toward a reduction in purchases later this year) to work its way into the policy statement. But they have to be careful because the market has not reacted well to hints of tapering," said Scott Brown, an economist at Raymond Jones in St. Petersburg, Florida.

The Fed cut interest rates to almost zero in late 2008 and has since more than tripled the size of its balance sheet to around $3.6 trillion via three massive rounds of bond buying aimed at holding down longer-term borrowing costs.

At a news conference on June 19, Fed Chairman Ben Bernanke said the central bank likely would start to curtail its current bond-buying round later this year, with an eye toward bringing it to a close by the middle of 2014.

But the U.S. economy is still lumbering through a soft patch induced by belt-tightening in Washington. A report on Wednesday is expected to show U.S. economic growth slowed to just a 1.0 percent annual pace in the second quarter, down from 1.8 percent in the prior three months.

As a result, the Fed will be careful to stress that any action it takes will be conditional on the economy improving. Officials will want to avoid the type of market maelstrom touched off when Bernanke laid out the plan for trimming bond purchases, comments that spooked stock and bond markets alike.

While reassurances from Bernanke and other Fed officials that any pull-back of purchases did not mean the central bank was getting anywhere near jacking up interest rates helped contain the market fallout, the yield on the benchmark 10-year U.S. Treasury note still stands about a full percentage point above where it was in early May. Mortgage rates have risen a similar amount, posing a potential risk to the housing recovery.

RATE HIKE EXPECTATIONS

It is also possible that Fed officials will adjust the economic thresholds they have laid out to guide expectations about when they eventually will begin to raise rates. The Fed has vowed to hold rates near zero until the unemployment rate hits 6.5 percent, provided the outlook for inflation does not push above 2.5 percent.

The head of the Minneapolis Federal Reserve Bank, Narayana Kocherlakota, advocates reducing the jobless rate threshold to 5.5 percent to signal that any rate hikes are a long way off. Bernanke last month said officials might agree to a lower figure.

But Fed watchers view a change at the current meeting as unlikely, partially because of difficulties among the officials in gaining sufficient consensus.

"A threshold of 5.5 percent would put the point of the funds rate lift-off well below where six persons on the committee see the natural unemployment rate," JPMorgan economist Michael Feroli wrote in a note to clients, referring to the level of unemployment officials think can be achieved without touching off inflation.

Quarterly Fed projections in June showed six of the 19 officials on the committee saw the long-run or natural rate of U.S. unemployment lying between 5.8 percent and 6.1 percent.

Instead, Feroli said the chances were better that the Fed might alter its inflation threshold to stipulate that rates would not be lifted if inflation was running too low - say under 1.5 percent. The Fed's preferred inflation gauge was up just 1 percent in the 12 months through May.

"Complementing the current 2.5 percent inflation ceiling with a 1.5 percent inflation floor seems perfectly reasonable," said Feroli.

(Reporting by Alister Bull; Editing by Diane Craft)