WASHINGTON -- Chairman Ben Bernanke ended weeks of speculation Wednesday by saying the Federal Reserve will likely slow its bond-buying program later this year and end it next year if the economy continues to improve.
The Fed's bond purchases have helped keep long-term interest rates at record lows.
Mr. Bernanke said the reductions would occur in "measured steps" and that the purchases could end by the middle of next year. By then, he said he thought unemployment would be around 7 percent.
Mr. Bernanke likened any reduction in the Fed's $85 billion-a month in bond purchases to a driver letting up on a gas pedal rather than applying the brakes.
Anticipating higher interest rates, investors reacted by selling both stocks and bonds. The Dow Jones industrial average was down 206 points in late-afternoon trading after Mr. Bernanke's news conference ended.
The Fed sketched a brighter economic outlook Wednesday, which is why it thinks record-low interest rates may soon no longer be necessary. Low rates help fuel economic growth. But they also raise the risk of high inflation and dangerous bubbles in assets like stocks or real estate.
Speaking of the economy, Mr. Bernanke said, "The fundamentals look a little better to us."
He spoke at a news conference after the Fed ended a two-day policy meeting. After the meeting, the Fed voted to continue the pace of its bond-buying program for now. But it offered a more optimistic outlook for the U.S. economy and job market.
In its statement, the Fed said the economy is growing moderately. And for the first time it said the "downside risks to the outlook" had diminished since fall.
Timothy Duy, a University of Oregon economist who tracks the Fed, called the statement "an open door for scaling back asset purchases as early as September."
The fact that the Fed foresees less downside risk to the job market "gives them a reason to pull back" on its bond purchases, Mr. Duy said.
The Fed said 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.
Asked if it will be difficult for the Fed to clearly communicate its plans for scaling back the bond purchases, Mr. Bernanke agreed. "We are in a more complex type of situation," he said. "We are going to be as clear as we can."
In its statement Wednesday, the Fed said it would maintain its plan to keep short-term rates at record lows at least until unemployment reaches 6.5 percent.
The Fed also released its latest economic projections. Officials predicted that unemployment will fall a little faster this year, to 7.2 percent or 7.3 percent at the end of 2013 from 7.6 percent now. They think the rate will be between 6.5 percent and 6.8 percent by the end of 2014, better than its previous projection of 6.7 percent to 7 percent.
The Fed also said inflation was running below its 2 percent long-run objective, but noted temporary factors were partly the reason. It said inflation could run as low as 0.8 percent this year. But it predicts it will pick up next year to between 1.4 percent and 2 percent.
"The more upbeat tone and the change in the unemployment forecast will only encourage expectations for action soon," Jim O'Sullivan, chief U.S. economist at High Frequency Economics, wrote in a research note. "We continue to believe that tapering could start at the Sept. 17-18 meeting."
David Robin, co-head of the futures and options desk at the brokerage Newedge, said he didn't think Mr. Bernanke's upbeat assessment matches an economy that's just "muddling along."
Investors may suspect the Fed is looking for a reason to scale back the bond purchases, Mr. Robin said. "It's a big mess," he said.
The statement was approved on a 10-2 vote. James Bullard, the president of the Federal Reserve Bank of St. Louis, objected for the first time this year, saying he wanted a stronger commitment from the Fed to keep inflation from falling too low.
Esther George objected for the fourth time this year, again voicing concerns about inflation rising too quickly.
During his news conference, Mr. Bernanke declined to address speculation that he will step down as Fed chairman when his term ends in January.
He was asked to respond to comments Monday by President Barack Obama, who said Mr. Bernanke had already stayed longer than planned. The president's remarks added to expectations that Mr. Bernanke intends to step down.
"I would like to keep the discussion on monetary policy," Mr. Bernanke said. "I don't have anything for you on my personal plans."
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 gyrating in the four weeks since Mr. Bernanke told Congress the Fed might scale back its effort to keep long-term rates at record lows within "the next few meetings"-- earlier than many had assumed.
He cautioned that the Fed would slow its support only if it felt confident the job market would show sustained improvement. And he also told lawmakers that the Fed must take care not to prematurely reduce its stimulus for the still-subpar economy.
• Stocks sink after Fed statement. Story, Page C-6