UPDATED: Fed maintains QE, optimistic about U.S.

Conflicting statements from Fed officials and analysts have clouded the outlook for the bond-buying program. So people wanted the Fed to clarify its message this afternoon.

Read: Don’t fear the end of Fed QE

As expected, the Federal Reserve will maintain the pace of its QE program, which will keep long-term interest rates at record lows. But it did offer a more optimistic outlook for the U.S. economy and job market.

This brighter view of the economy could be a hint that the Fed is moving closer to reducing its bond purchases, though the statement issued after its two-day policy meeting gave no indication of when that might happen.

But that doesn’t mean Bernanke isn’t trying to prepare markets for the end of QE, says Paul Taylor, CIO of BMO Asset Management. Specifically, he says Bernanke was clear about two points.

First, downside economic risks are diminishing in the U.S., which means the country is normalizing, and he’s clearly saying tapering will happen “sooner rather than later,” adds Taylor. “People were kind of hoping his statements from the last meeting [about QE soon coming to an end] were taken out of context […] and they were trading on that hope.”

However, Taylor says Bernanke was being “very deliberate. QE tapering is coming and markets need to adjust to that reality.”

Second, Bernanke’s reference to a temporary dip in inflation was also conscious. Taylor says people were hoping Bernanke would not stop QE due to low inflation, but his comments were a “clear shot [to those investors] to say weaker, shorter-term data affecting inflation isn’t enough to stop the Fed from tapering.”

Further, the Fed knows markets will get the message. It’s being “as transparent as it can can be, and showcasing it will take its intended course of action.” BMO has maintained its prediction that QE tapering will begin in September and that it will occur in stages, with interest rates standing pat for a while after.

Taylor forecasts job numbers will improve following this announcement and climb steadily, which will help the Fed ease back on its extremely accommodative policy.

Investors reacted to the Fed announcement by selling both stocks and bonds. The Dow Jones industrial average was down 70 points shortly after the statement came out; minutes earlier, it had been down just 16. The yield on the 10-year Treasury note shot up to 2.27% from 2.21% just before the statement came out.

Taylor says Canadian investors should reallocate exposure from long-term to short-term bonds, “and pay attention to the coming uptick in interest rates,” given U.S. and Canadian bonds move together. That said, “Equities won’t be affected by any QE changes. They might be volatile short-term, but the Fed is being clear about its intentions and tapering will be priced in in real time.”

In conclusion, Taylor says he had hoped Bernanke would backtrack on his earlier hints and soften the blow to markets, but “he’s clearly signalling we need to prepare for a slowdown in QE.”

In its statement, the Fed says the economy is growing moderately, and Timothy Duy, a University of Oregon economist who tracks the Fed, told Canadian Press the statement is “an open door for scaling back asset purchases as early as September.”

The fact the Fed foresees less downside risk to the job market “gives them a reason to pull back” on its bond purchases, Duy adds.

The Fed says it will keep buying $85 billion a month in bonds until the outlook for the job market improves substantially. The goal is to lower long-term interest rates to encourage borrowing, spending and investing. It hasn’t defined substantially.

The central bank also said it would maintain its plan to keep short-term rates at record lows at least until unemployment reaches 6.5%. Further, it asserted inflation was running below its 2% long-run objective, but noted temporary factors were partly the reason.

The Fed also released its latest economic projections on Wednesday, which predicted that unemployment would fall a little faster this year, to 7.2% or 7.3% at the end of 2013 from 7.6% now. It thinks the rate will be between 6.5% and 6.8% by the end of 2014, better than its previous projection of 6.7% to 7%.

The ultra-low rates engineered by the Fed have helped fuel a housing comeback, support economic growth, drive stocks to record highs and restore the wealth America lost to the recession.

Financial markets have been more volatile in the four weeks since Chairman Ben Bernanke told Congress the Fed might scale back its effort to keep long-term rates at record lows within “the next few meetings.”

Bernanke cautioned the Fed would slow its support only if it felt confident the job market would show sustained improvement. And he also told lawmakers the Fed must take care not to prematurely reduce its stimulus for the still-subpar economy.

The Fed also announced after its September meeting that it would purchase $40 billion a month in mortgage bonds for as long as it deems necessary. And in December, the Fed expanded the program to $85 billion a month, adding $45 billion a month in Treasury bond purchases. The Treasury purchases replaced an expiring bond-purchase program.

Job growth picked up after the Fed announced the latest round of bond purchases. Since October, the economy has added an average of 196,500 jobs a month, up from 157,000 a month in the previous eight months.

Last month, the U.S. economy added a solid 175,000 jobs. But the unemployment rate is still high at 7.6%. Economists tend to regard the job market as healthy when unemployment is between 5% and 6%.