By Steven C. Johnson
NEW YORK (Reuters) - The Federal Reserve secured itself some wiggle room this week with the tactical deployment of three words in its policy statement: "modest," "mortgage" and "inflation."
In a statement many had expected to set the stage for a reduction in the central bank's massive stimulus starting as early as September, Fed officials' use of those three words instead introduced some doubt about their confidence in the strength of the economic recovery.
While the Fed said the U.S. economic recovery continued apace, it pledged to continue buying $85 billion of bonds each month and pointed to modest growth, higher mortgage rates and low inflation as risks to overall economic well-being.
Missing entirely was any mention of pulling back on bond purchases - also known as quantitative easing, or QE - this year, with an eye on ending them altogether by mid-2014. That had been the suggested timeline Fed Chairman Ben Bernanke disclosed as recently as June 19.
"It's pretty obvious that at some point in the near future, the Fed will start tapering. But there's a long way to go," said Thomas Simons, a money market economist at Jefferies & Co. "The general tilt of the Fed is still very accommodative."
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Blame the U.S. economy for that.
As Bernanke has repeatedly said, the Fed's timeline for winding down asset purchases was always going to be contingent on the overall health of the economy and whether it grows as quickly as central bank policymakers expect it to.
Sure, Fed officials may have been nodding to the economy's first-half underperformance when they downgraded their view of the recovery this week, saying the pace of growth was "modest" rather than "moderate," the previous adjective of choice.
Overall growth came in at a slim 1.1 percent in the first quarter before picking up to 1.7 percent between April and June.
But private sector economists agree that the economy has a lot of lost ground to make up if it is to deliver the kind of growth the central bank has penciled in. Many have noted that the economy would have to average 3.1 percent growth in the second half just to hit the low end of the Fed's expected 2.3 percent-to-2.6 percent growth range for 2013.
"I reckon it's a tall order to achieve that growth pace," said Thomas Lam, an economist at OSK-DMG.
The average estimate of economists in a recent Reuters poll puts second half growth at 2.45 percent [ID:nN9N0EF018]
To be sure, recent data has been encouraging. Reports this week showed manufacturing activity hitting a two-year high last month and a private sector job gain of 200,000.
A strong showing in Friday's more comprehensive nonfarm payrolls report for July and another one for August could convince the Fed to start pulling back sooner rather than later.
But if growth remains sluggish, the Fed may have to cut its economic forecasts for a second time this year come September, said Bank of America Merrill Lynch economist Michael Hanson.
"So it would take a real pirouette for them to say, on the one hand, they're going to revise down their growth estimates, perhaps significantly, and possibly their inflation forecasts too, and at the same time say they're going to taper," he said referring to reduced bond buying.
Chances are, such a mixed message would spook markets again and set off volatility similar to that seen in May and June when Bernanke starting giving hints about such a reduction in stimulus. Fed officials spent much of June and early July jawboning to slow a sharp rise in long-term interest rates that pushed benchmark 10-year Treasury yields to 2.75 percent. They stood more than a percentage point lower at the start of May.
"It could happen. But I still think the market put too much stock in the idea that (tapering in) September was a done deal. And now some of that is getting priced out," said Hanson, who thinks the Fed will probably wait until December to scale back.
HURDLE FOR HOUSING
Some Fed officials have said in private that it should not matter much if the reduction in bond buying starts in September or December.
Either way, the Fed's balance sheet will still total more than $4 trillion, reflecting the massive size of the stimulus it has provided the overall economy, and the decision over a September or December start would have an impact on only the final few billion dollars of purchases.
"Whether we were to adjust our purchases at one meeting or another is not the biggest decision," San Francisco Fed President John Williams told reporters last month. "What we want to try to do is have our policy continue to support growth."
One area where that could prove a challenge is housing, a bright spot for the economy recently. Prices have risen steadily for more than a year.
But the rise in long-term bond yields has also pushed 30-year fixed-rate mortgages up by more than a full percentage point since May to just under 4.6 percent, raising the possibility that the housing recovery's foundation was built on sand rather than solid rock.
Applications for loans to buy a home have tumbled 13 percent since hitting a post-recession high in May, according to the Mortgage Bankers Association, and existing home sales fell unexpectedly in June. Barring a pick-up in mortgage originations, economists worry that softness could continue.
"They highlighted the increase in mortgage interest rates, implying they are nervous about downside risks higher mortgage rates might pose to housing," said Michael Moran, economist at Daiwa Securities America. "This has implications for QE because if you are concerned about downside risks in the housing market, which is supposed to be an engine of growth, you're not going to taper until you're confident you have withstood the challenges."
REDISCOVERING INFLATION
Perhaps most notable of all, the Fed this week seemed to rediscover its focus on inflation, or rather the lack of it.
Since cutting interest rates to zero in 2008 and through three subsequent rounds of massive bond purchases, Bernanke has focused on the danger of excessively low inflation, which can be a trigger for an economic downturn as companies find they cannot raise prices for consumer or corporate customers.
Those concerns seemed to fade in May when the Fed chief first hinted at reducing the stimulus. The only problem was that inflation started showing signs of moving farther below the Fed's 2 percent target, not toward it.
The Fed has stressed that it sees the slide as temporary. Even so, it raises the bar for a September QE reduction even higher.
Even the Institute for Supply Management's impressively strong July manufacturing report on Thursday showed an outright decline in prices paid, perhaps a hint of overseas weakness, in China, for instance.
"It certainly makes it more awkward for them to start wrapping up this round of QE," said Mike Dueker, chief economist at Russell Investments in Seattle.
The Fed's renewed expression of concern about disinflation may be a concession to St. Louis Fed President James Bullard, who said worries about prices prompted his dissent against the June decision to move toward scaling back stimulus.
But Bank of America Merrill Lynch's Hanson said it also reflected policymakers' underlying worries over such a low rate of inflation this far into the economic recovery. What's more, it is a reminder that some contributing factors are beyond the Fed's control.
"The last time we had any real rise in inflation was 2011 and it was mostly commodity-price driven," he said. "But that was a world where emerging markets were recovering, Europe was not yet mired in recession. There are a lot of differences now."
(Additional reporting by Ann Saphir in Chicago and Pedro da Costa and Alister Bull in Washington; Editing by Dan Burns, Martin Howell and Dan Grebler)