Fed says economy is leveling out

The Federal Reserve said on Wednesday the U.S. economy was showing signs of leveling out two years after the onset of the deepest financial crisis in decades and it moved to phase out one emergency measure.

The U.S. central bank also kept its benchmark short-term interest rate steady near zero and said it would likely stay there for an extended period to guide the way to recovery.

The Fed made its clearest statement to date that it sees the recession nearing an end and that shattered financial markets are healing.

Information since the Federal Open Market Committee met in June suggests economic activity is leveling out, the Fed said, referring to its policy-setting panel. Conditions in financial markets have improved in recent weeks.

It is the first time since August 2008 that the committee's statement has not characterized the economy as contracting, weakening, or slowing.

Many peg the onset of the crisis to French bank BNP Paribas' move in August 2007 to freeze funds because of problems with U.S. subprime mortgages. In the months that followed, the U.S. economy toppled into the most damaging financial crisis and painful recession in decades, and the economic malaise spread around the world.

They see the worst with the economy is behind us but they don't want to jump the gun and pull back quickly, said Craig Thomas, a senior economist at PNC Financial Services in Pittsburgh.

The Fed cautioned that the economy remains fragile as employers continue to cut jobs and businesses trim investment.

U.S. Treasury prices fell after the Fed statement in apparent disappointment that the Fed did not increase the amount of debt that it plans to buy but subsequently regained some ground.

However, major U.S. stock indexes flirted with 10-month highs and the U.S. dollar rose against the yen.

The Fed cut interest rates to a range of between zero and 0.25 percent in December and pumped hundreds of billions of dollars into financial markets to stimulate economic activity in aggressive efforts to thwart the recession.

President Barack Obama's ability to implement his health care and environmental reforms partly depend on his administration's ability to turn the economy around with a controversial $787-billion economic stimulus package.

The recession has seen tax revenues fall and spending rise, leading to a record federal budget deficit expected to top $1.84 trillion in the current fiscal year.

Fed Chairman Ben Bernanke's own renomination hopes for a second term have a lot riding on his ability to restore growth and jobs after the Fed's role in controversial financial rescues and after questions about why the Fed did not spot the gathering storm earlier and take steps to prevent it.

Recent reports imply that the economy may be coming out of its swoon and that job losses, which have topped 6 million since the recession began in December 2007, may be moderating.

Still, the Fed renewed its warning that economic activity is likely to stay soft for a time. Household spending, while stabilizing, is still weak as a result of the grim labor market and tight credit, the Fed said.

To quell worries the Fed's bloated balance sheet may sow the seeds of dangerous inflation once the recovery gains traction, Bernanke has taken pains to explain the Fed has tools to pull money out of the financial system to prevent price pressures from building.

Some analysts also worry the Fed's easy money policies are setting the stage for another asset bubble, just as an extended period of low rates in the early part of the decade encouraged the housing boom that triggered the crisis.

The central bank cautiously moved to pull back some of that help for the economy on Wednesday, signaling it would slowly phase out a program to buy $300 billion in longer-term Treasuries by the end of October.

To promote a smooth transition in markets as these purchases of Treasury securities are completed, the committee has decided to gradually slow the pace of these transactions

and anticipates that the full amount will be purchased by the end of October, the Fed said.

The Fed launched the debt-buying program in March when it had already chopped interest rates to zero but wanted to open the money taps even wider to support the struggling economy. Treasury purchases were scheduled to expire in September.

The Fed's decision to refrain from expanding its bond buying while standing pat on rates contrasts with approaches taken by other central banks around the world faced different stages of economic and financial stabilization.

The Bank of England stunned markets last week by expanding its program of bond purchases by a much larger amount than expected, saying the recession deeper than it had forecast.

(Editing by Neil Stempleman)