Fed says U.S. recovery is underway

By Mark Felsenthal and Alister Bull

WASHINGTON (Reuters) - The Federal Reserve on Wednesday upgraded its assessment of the U.S. economy, saying growth had returned after a deep recession, while reiterating its promise to hold interest rates very low for a long time.

The Fed also said it would slow its purchases of mortgage debt to extend that program's life until the end of March, in a move toward withdrawing the central bank's extraordinary support for the economy and markets during the contraction.

The U.S. central bank, as widely expected, held its benchmark overnight lending rates at close to zero percent.

"Information received since the Federal Open Market Committee met in August suggests that economic activity has picked up following its severe downturn," the Fed said in a statement after its two-day policy meeting.

"Conditions in financial markets have improved further and activity in the housing sector has increased," it said.

U.S. government bond yields ended lower on the news that the central bank had reiterated a pledge to keep rates ultra-low for an extended period.

"I think it confirms that the economy still needs a little bit of help and that rates aren't going to go up anytime soon," said Alan Lancz at Alan B. Lancz & Associates in Toledo, Ohio.

But a stock market rally fizzled on concerns the Fed was setting the stage for pulling back from its efforts to stimulate the economy. The Dow Jones industrial average ended down 81.77 points or 0.83 percent at 9,748.10.

"There's still a lot of problems with mortgages, the housing market in general as well as the banking sector," said Dan Faretta, a market strategist at Lind-Waldock, a brokerage firm, in Chicago.

The Fed said it would gradually slow the pace of its purchases of mortgage-related debt in order to promote a smooth transition in markets as the Fed has been the biggest buyer.

But it made clear it would purchase the full amount of $1.25 trillion in agency mortgage-backed securities. In its August statement the Fed had said it would buy "up to" that amount, but dropped those two words on Wednesday.

At least one member of the Fed's policy-setting committee had proposed curtailing mortgage-backed securities purchases, saying they provide too much of a boost as recovery takes off.

The Fed doubled the size of its balance sheet to more than $2 trillion as it flooded financial markets with money during the crisis last year.

Some policy-makers worry the bloated balance sheet risks triggering inflation if the Fed waits too long before removing its stimulus measures and raising interest rates.

However, the U.S. central bank on Wednesday played down concerns about price pressures in an economy where the jobless rate is at a 26-year high and factory capacity is greatly underutilized.