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Fed keeps faith in recovery, bumps up expected rate-hike path

By Howard Schneider and Jason Lange

WASHINGTON (Reuters) - The Federal Reserve on Wednesday expressed confidence the U.S. economic recovery was on track and hinted at a slightly more aggressive pace of interest rate increases starting next year.

At the same time, however, officials at the central bank lowered their projections for the long-run target interest rate, evidence of slightly diminished expectations for a nation climbing out of a severe crisis and struggling with demographic headwinds like declining labor force participation.

As widely expected, the Fed pushed ahead with plans to wind down one of its main stimulus programs, reducing its monthly asset purchases from $45 billion to $35 billion beginning in July.

At an afternoon news conference, Fed Chair Janet Yellen provided a long list of reasons for short-run confidence - from resilient household spending to an improving jobs market. Though officials slashed their growth forecast for 2014 from 2.9 percent to a range of between 2.1 percent and 2.3 percent, Yellen said that was the result of "transitory" factors like a severe winter and that a rebound was underway.

"Economic activity is rebounding in the current quarter and will continue to expand at a moderate pace," she said. "The economy is continuing to make progress towards our objectives" of full employment and 2 percent inflation.

But Yellen said there had been "a slight decline of projections pertaining to longer term growth" that prompted Fed officials to lower their view of the expected long-term federal funds rate from 4 percent to 3.75 percent.

That is below the 4.25 percent historical level identified by New York Federal Reserve President William Dudley.

The Fed's two-day meeting ended with the central bank still comfortable in a situation where inflation is slowly edging up, unemployment is falling and growth is expected at around 3 percent for the next two years - above the long-term trend.

That prompted the central bank's policy-making ranks, joined by new members including Vice Chairman Stanley Fischer, to indicate rates will rise a bit higher over the next two years compared to their last round of quarterly projections in March.

The Fed cut overnight rates to near zero in December 2008 as it battled the financial crisis and deep recession, and the timing and pace of future rate increases is one of the key decisions facing the central bank as the recovery evolves.

Of 16 individual rate hike projections submitted for this meeting, 13 officials said rates should begin rising next year. The median projection for rates at the end of 2015 was 1.125 percent, up slightly from March. Officials projected a slightly more aggressive path of rate hikes for 2016, with the end-year median placed at 2.5 percent versus 2.25 percent in March.

The higher median projections were far from a sign of emerging consensus, however, with forecasts more dispersed than they had been three months ago.

Stocks had a muted reaction to the Fed statement, but rallied following Yellen's comments. The S&P 500 rose to close at an all-time record, while the 10-year U.S. Treasury note rose in price to lower its yield to 2.59 percent.

'STEADY AS SHE GOES'

The Fed's policy statement changed little from the one issued after its last meeting in April, repeating that interest rates would remain near zero "for a considerable time" after the bond buying ends. The Fed said unemployment remained "elevated" despite recent job growth, and noted that its preferred measure of inflation was still running below target.

"Steady as she goes, with respect to policy," said Kim Rupert, managing director at Action Economics in San Francisco. "A lot of the doves want to make sure the recovery is for real."

Yellen has warned in the past against interpreting the individual rate projections as a clear indication of how the policy committee is likely to move. She cautioned that the arrival of new members and the departure of former Fed Governor Jeremy Stein made it difficult to compare the anonymous projections with those made in March.

Yellen said there was also no agreement yet over how to manage monetary policy as an era of crisis response closes.

In its policy statement, the Fed said it would continue reinvesting the proceeds of its asset holdings as they mature, meaning the central bank's $4.3 trillion balance sheet will for now remain intact. Policymakers are debating how and when to shrink those holdings, and how to manage interest rates given the large amount of cash pumped into the banking system by different crisis programs.

"We have made a lot of progress but we have not yet reached conclusion," Yellen said, adding she expects a more detailed plan to be released later this year.

In cutting their 2014 growth forecast, officials took into account the sour start the economy got this year after severe winter weather crippled activity in major cities around the country. The government said last month that GDP shrank at a 1 percent annual rate, and economists say data since then imply a much deeper contraction.

Although growth now appears to be bouncing back, there remain weak spots, particularly in the housing sector. Fed officials described risks to the economy and labor market as "nearly balanced."

(Reporting by Howard Schneider and Jason Lange; Editing by Timothy Ahmann, Meredith Mazzilli and Paul Simao)

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