Fed lays out terms to raise interest rate

WASHINGTON — The Federal Reserve for the first time Wednesday linked the outlook for its main interest rate to unemployment and inflation.

The Fed said it plans to keep its key short-term rate near zero at least until the unemployment rate drops below 6.5 percent — as long as inflation remains tame. Unemployment is now 7.7 percent.

That plan adds detail to what the Fed had said before: that it expects to keep the rate low until at least mid-2015.

“The conditions now prevailing in the job market represent an enormous waste of human and economic potential,” Fed Chairman Ben Bernanke said at a news conference in Washington after a meeting of the Federal Open Market Committee. The Fed plans to “maintain accommodation as long as needed to promote a stronger economic recovery in the context of price stability,” he said.

In a statement Wednesday after its final policy meeting of the year, the Fed also said it will keep spending $85 billion a month on bond purchases to drive down longterm borrowing costs and stimulate economic growth.

The Fed will spend $45 billion a month on longterm Treasury purchases to replace a previous bond-purchase program of an equal size. And it will keep buying $40 billion a month in mortgage bonds.

“The Fed has become more explicit and more transparent,” said Steven Wood, chief economist at Insight Economics. “This should provide the markets with much more clarity around monetary policy action in the upcoming year.”

Stocks erased gains as Bernanke said the Fed can’t offset the full impact in case the Obama administration and Congress can’t reach an agreement to avoid automatic tax increases and spending cuts set to take effect next year. The Dow Jones industrial average fell 2.99 points to 13,245.45.

The Fed’s new plan to link any rate increase to specific levels of unemployment and inflation mirrors proposals pushed by Charles Evans, president of the Federal Reserve Bank of Chicago, and by James Bullard, president of the Federal Reserve Bank of St. Louis. Bullard suggested the Fed consider specific economic triggers in a speech at the Little Rock Regional Chamber of Commerce’s annual meeting Dec. 3.

With its new purchases of long-term Treasurys, the Fed’s investment portfolio, which is nearly $3 trillion, would swell to nearly $4 trillion by the end of 2013 if its bond-purchase programs remain in place.

The policies are intended to help an economy that the Fed said is growing only modestly.

The Fed’s plan to keep stimulating the economy at least until unemployment has reached 6.5 percent is intended to reassure consumers, companies and investors, said Joseph Gagnon, a former Fed official who is a senior fellow at the Peterson Institute for International Economics.

Having a target date of mid-2015 for any increase in interest rates “sounded gloomy,” as if the economy would remain weak until then, Gagnon said. Specifying an unemployment rate — close to a normal rate of 6 percent or less — makes clear that the Fed will keep stimulating the economy even after the job market has strengthened. Three years into a recovery from recession, the nation’s unemployment rate remains higher than Fed officials’ estimates for full employment, which range from 5.2 percent to 6 percent.

Updated forecasts that the Fed released Wednesday illustrate why it thinks it should continue stimulating the economy. It expects unemployment to remain at least 7.4 percent next year and 6.8 percent by the end of 2014. The earliest it sees unemployment dropping below 6.5 percent is the end of 2015.

It expects the economy to grow no more than 3 percent next year before picking up to 3.5 percent in 2014 and 3.7 percent in 2015.

The slow pace of inflation has made the Fed’s policy shift easier. The Fed said it expects prices to rise at or below the 2 percent annual pace that it considers most healthy. But the Fed also said that it was inclined to tolerate mediumterm inflation as high as 2.5 percent without breaking its focus on reducing the unemployment rate.

The meeting was held against the backdrop of the sharp tax increases and spending cuts that will hit the economy in January if Congress and President Barack Obama are unable to reach an agreement this month to avert them.

Bernanke has said the Fed’s efforts will not be able to rescue the economy if the budget negotiations fail.

Fear of looming tax increases has led some U.S. companies to delay expanding, investing and hiring. Manufacturing has slumped. Consumers have cut back on spending. Unemployment remains elevated. If higher taxes and government spending cuts were to last for much of 2013, most experts say the economy would sink into another recession.

The latest bond-buying program would replace an expiring program called Operation Twist. With Twist, the Fed sold $45 billion a month in short-term Treasurys and used the proceeds to buy the same amount in longer-term Treasurys.

Operation Twist didn’t expand the Fed’s investment portfolio; it just reshuffled the holdings. But the Fed has run out of short-term securities to sell. So to maintain its pace of long-term Treasury purchases and to keep long-term rates low, it must spend more and increase its portfolio.

The Fed’s portfolio totals nearly $2.9 trillion — more than three times its size before the 2008 financial crisis.

The Fed has launched three rounds of bond purchases since the financial crisis hit. In announcing a third program in September, the Fed said it would keep buying mortgage bonds until the job market improved substantially.

Skeptics note that rates on mortgages and many other loans are already at or near all-time lows. So any further declines in rates engineered by the Fed might offer little economic benefit.

Inside and outside the Fed, a debate has continued over whether the Fed’s actions have helped support the economy over the past four years, whether they will ignite inflation later and whether they should be extended.

The Fed’s statement was approved on an 11-1 vote. Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, Va., objected for the eighth time this year. He has repeatedly called for the Fed to do less.

Information for this article was contributed by Martin Crutsinger of The Associated Press; by Joshua Zumbrun, Jeff Kearns and Caroline Salas Gage of Bloomberg News; and by Binyamin Appelbaum of The New York Times.