WRAPUP 5-Fed surprises, sticks to stimulus as it cuts growth outlook
* In surprise, keeps buying $85 billion in bonds
* Cites higher mortgage rates, fiscal policy headwinds
* Fed does not change threshold for raising rates
* Stocks and bonds both rally, dollar sells off
WASHINGTON, Sept 18 (Reuters) - The U.S. Federal Reserve said on Wednesday that it would continue buying bonds at an $85 billion monthly pace for now, expressing concerns that a sharp rise in borrowing costs in recent months could weigh on the economy.
The decision surprised financial markets, which were braced for a modest cut in the central bank's economic stimulus, and Fed Chairman Ben Bernanke refused to commit to a tapering of purchases later this year, as he had previously suggested.
"There is no fixed calendar schedule. I really have to emphasize that," he told a news conference. "If the data confirm our basic outlook, if we gain more confidence in that outlook ... then we could move later this year."
Stocks rallied on the U.S. central bank's decision, with the S&P 500 index hitting a record high. The dollar fell to a seven-month low against the euro, while prices for U.S. government bonds rose sharply. The price of gold, a traditional inflation hedge, also shot higher.
"The Federal Reserve remains quite concerned about the overall sluggishness of the economy, preferring to take the risk of being too loose for too long as opposed to tighten prematurely," said Mohamed El-Erian, co-chief investment officer at Pimco, which manages the world's largest mutual fund.
In fresh quarterly projections, the Fed cut its forecast for 2013 economic growth to a 2 percent to 2.3 percent range from a June estimate of 2.3 percent to 2.6 percent. The downgrade for next year was even sharper.
It cited strains in the economy from tight fiscal policy and higher mortgage rates as it explained why it decided to maintain asset purchases at the current pace.
"The tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market," it said in a statement.
MAKING SLOW PROGRESS
Nevertheless, the Fed said the economy was still making progress despite tax hikes and budget cuts in Washington.
"Taking into account the extent of federal fiscal retrenchment, the committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program a year ago as consistent with growing underlying strength in the broader economy," it said.
And policymakers made clear they were still mulling exactly when to ratchet back their bond-buying stimulus.
"The committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases," the Fed added.
Bernanke had stated in June that officials expected to begin slowing the pace of purchases later this year and end the program by mid-2014, at which point the central bank expected unemployment to be around 7 percent.
In his less committal statement on Wednesday, he said a jobless rate of 7 percent was not a "magic number" that policymakers were shooting for as they figure out when to halt the buying.
"We could begin later this year. But even if we do that, the subsequent steps will be dependent on continued progress in the economy," Bernanke said. "We don't have a fixed calendar schedule. But we do have the same basic framework that I described in June."
The decision faced a single dissent, from Kansas City Federal Reserve Bank President Esther George, who again voted against her colleagues, saying she was worried about financial bubbles due to the Fed's low rate policy. Fed Governor Sarah Raskin, who has been nominated to take a top job at the U.S. Treasury, did not participate in the meeting.
The Fed has held rates near zero since late 2008 and has more than tripled its balanced sheet to more than $3.6 trillion through three rounds of massive bond purchases aimed at holding borrowing costs down.
The Fed reiterated that it will not start to raise rates at least until unemployment falls to 6.5 percent, so long as inflation does not threaten to go above 2.5 percent. The U.S. jobless rate in August was 7.3 percent.
Most policymakers, 12 out of 17, projected the first hike in overnight interest rates would not come until 2015, even though the forecasts suggested they would likely hit their threshold for considering a rate hike as early as next year.