BY MARTIN CRUTSINGER
The Federal Reserve cautioned America's political leaders Wednesday that their policies are hurting the economy.
The Fed stood by its aggressive efforts to stimulate the economy and reduce unemployment. But it sent its clearest signal to date that tax increases and spending cuts that kicked in this year are slowing the economy.
"Fiscal policy is restraining economic growth," the Fed said in a statement after a two-day policy meeting.
The Fed maintained its plan to keep short-term interest rates at record lows at least until unemployment falls to 6.5 percent from its current 7.6 percent. And it said it will continue to buy $85 billion a month in Treasury and mortgage bonds. The bond purchases are intended to keep long-term borrowing costs down and encourage borrowing and spending.
The minutes of the previous policy meeting in March showed that many Fed officials were open to reducing the bond purchases before year's end, so long as the economy improved. But Wednesday's statement indicated that Fed officials are also open to expanding the bond buying if the economy needs it.
The Fed's statement signaled its concern about a Social Security tax increase, which took effect Jan. 1, and deep government spending cuts, which began taking effect March 1. The across-the-board spending cuts took effect automatically after Congress failed to reach a budget deal.
Joel Naroff, chief economist at Naroff Economic Advisors, said he viewed the Fed's more forceful remarks on the issue as criticism of Congress' fiscal policies.
"The Fed noted that the private economy is pushing ahead, but it is the government that is putting roadblocks in the way," Naroff said. "That was as clear a shot at Congress as I have seen the Fed take."
Democrats in Congress generally agreed with the Fed's criticism while Republicans took exception.
"Jobs and economic growth should be our top priority right now, which is exactly why we need to replace the irresponsible across-the-board cuts from sequestration with pro-growth and sustainable fiscal policies," said Senate Budget Committee Chairman Patty Murray, D-Wash.
But House Financial Services Committee Chairman Jeb Hensarling said that the Fed's easy money policies had not helped the economy. "America is nearly five years into the Fed's historically unprecedented interventionist policies and there is very little gain to show for it," said Hensarling, R-Texas.
Paul Edelstein, director of financial economics at IHS Global Insight, said the Fed's point that fiscal policy is restraining the economy was a reminder to investors "that flexibility runs in both directions."
"If conditions deteriorate, the Fed will do more," Edelstein said.
Two years ago, Chairman Ben Bernanke argued at a Fed conference in Jackson Hole, Wyo., that Congress should do more to stimulate hiring and growth. Since then, Congress hasn't joined the Fed in trying to stimulate growth. Instead, congressional leaders have focused on deficit reduction and allowed tax increases and spending cuts to take effect.
In its statement Wednesday, the Fed made clear that it could increase or decrease its bond purchases depending on the performance of the job market and inflation.
David Jones, chief economist at DMJ Advisors, said that in saying it could increase or decrease its bond purchases, the Fed wants to show flexibility: It's ready to respond, whether the economy improves or weakens significantly.
"I think the Fed is in a wait-and-see mode, like the rest of us," Jones said.
Jones said he expects no change in the level of bond purchases until September or later. The Fed wants time to see whether the economy can grow fast enough to drive sustained improvement in the job market, he said.
The Fed's statement appeared to cause little response in the stock market, which fell sharply on signs of a slowdown in hiring and manufacturing and weak earnings reports from some major companies. The Dow Jones industrial average sank 138 points, or nearly 1 percent.
Debate among Fed policymakers at their previous meeting in March had led some economists to speculate that the Fed might scale back its bond purchases if job growth accelerated.
But several reports in recent weeks have suggested that the economy might be weakening. Employers added only 88,000 jobs in March, far fewer than the 220,000 averaged in the previous four months. On Friday, economists expect the government to report that employers added about 160,000 jobs in April.
And the economy grew at an annual rate of 2.5 percent in the January-March quarter — a decent growth rate but one that's expected to weaken in coming months because of the higher Social Security taxes and federal spending cuts.
At the same time, consumer inflation as measured by the gauge the Fed most closely monitors remains well below its 2 percent target. That gauge rose just 1 percent in the 12 months that ended in March. Low inflation gives the Fed room to keep interest rates low without igniting price increases.
When prices fall too low, though, they raise the risk of deflation — a prolonged drop in wages, prices and the value of assets like stocks and houses. The United States last suffered serious deflation during the Great Depression of the 1930s. Fed policymakers worry about possible deflation any time inflation dips below 2 percent.
The Fed's efforts to drive down unemployment and raise inflation to its target rate mean it isn't meeting either of its dual mandates: to maximize employment and maintain price stability. That makes it more likely that the Fed will maintain its current level of bond purchases until the end of the year or later.
"We expect the Fed will maintain the current purchase pace into early 2014, then taper gradually," Michael Hanson, a senior economist, wrote in a report for BofA Merrill Lynch Global Research.
The Fed has been joined by other major central banks in seeking to strengthen growth and reduce high unemployment.
The European Central Bank could cut its benchmark lending rate from a record low of 0.75 as soon as Thursday because the euro area's economy remains stagnant.
Unemployment for the eurozone is 12.1 percent. And the ECB predicts that the euro economy will shrink 0.5 percent in 2013.
Japan's central bank has acted to flood its financial system with more money to try to raise consumer prices, encourage borrowing and help pull the world's third-largest economy out of a prolonged slump. Economists say Japanese consumers will spend more if they know prices are going to rise.
The Bank of Japan has kept its benchmark rate between 0 and 0.1 percent to try to stimulate borrowing and spending.
The Fed's action Wednesday was supported on an 11-1 vote. Esther George, president of the Kansas City regional Fed bank, dissented for a third straight meeting. The statement said George remained concern that the Fed's aggressive stimulus could heighten the risk of inflation and financial instability.
Associated Press reporter Alan Fram contributed to this report.