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Investors await Fed stimlulus decision

The financial crisis was in full swing when the Federal Reserve started furiously pumping money into the U.S. economy in November 2008 in a bid to keep it functioning. More than five years later, officials with the central bank meeting in Washington this week are trying to resolve a vital question: Is the economic recovery strong enough to start turning off the tap?

Members of the Fed's policy-setting panel on Wednesday will offer their latest prognosis for the economy. Financial markets closed flat Tuesday as investors wait to see whether policy-makers will start "tapering" the Fed's $85 billion-a-month program to buy U.S. Treasury and mortgage securities. The purchases are aimed at stimulating economic growth by keeping longer-term interest rates low, encouraging consumers and businesses to borrow and invest. 

By that measure, the Fed's decision about when to reduce the bond purchases, also called "quantitative easing," represents a key litmus test for the economy. Pull back on the stimulus stick too soon and the economy could stall; wait too long and it could overshoot the runway, triggering inflation.

Most forecasters expect the Fed to wait until early 2014 to scale back its bond purchases, but for different reasons than earlier in the year. While sluggish job growth through the first nine months of 2013 is what made most Fed members reluctant to remove stimulus, now the main obstacle is weak inflation. Weak price growth hinders business expansion and holds down wages, which constrains economic activity.

Employers added 200,000 jobs in October and an additional 203,000 jobs last month, a sign that the labor market is finally gaining speed. By contrast, inflation is running at 1.2 percent compared with the year ago-period, well below the Fed's 2 percent target, and has declined in recent months.

Michael Hanson, senior economist with Bank of America Merrill Lynch thinks that will be enough to dissuade the central bank's rate panel, the Federal Open Market Committee, from starting to withdraw stimulus at tomorrow's policy meeting. 

There's another reason the Fed is likely to wait a month or two before easing its bond purchases. Back in May, taper talk by Ben Bernanke caused bond yields to surge, raising borrowing costs for mortgages and other loans. With the recovery showing signs of momentum, the FOMC may err on the side of caution and leave policy unchanged until they have more data to suggests economic growth is on track.

"Officials are still worried about mortgage rates spiking higher, causing an unwelcome further tightening of financial conditions," said Jim O'Sullivan, chief U.S. economist with High Frequency Economics in a note to clients.

Finally, the Fed may hold off simply to avoid surprising financial markets. Although stronger job-creation has increased the odds of a December taper, most investors do not expect the FOMC to move until its policy meeting in January or March, according to Goldman Sachs (GS) analysts.

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