Fed keeps short-term rates unchanged
By Holden Lewis • Bankrate.com

Short-term interest rates will remain the same, courtesy of a Federal Reserve that's expected to leave rates alone for a while.

The central bank's rate-setting Open Market Committee kept its target for the federal funds rate unchanged today at 5.25 percent. The prime rate will remain 8.25 percent. Some types of consumer debt, such as variable-rate credit cards and home equity lines of credit, are pegged to the prime rate. They will remain unchanged.

It's impossible to predict the effect of the Fed's decision on longer-term interest rates, such as those for fixed-rate mortgages and auto loans. Those rates are set by the market, not by the Federal Reserve. They move up and down in response to many factors, including investors' inflation expectations and the demand for American debt from our foreign trading partners (they're eager to lend to us, and that keeps rates down).

Meeting eight times a year, the Fed raised the target federal funds rate 17 times in a row, a quarter-point each time, from June 2004 to June 2006. The Fed has held steady since then. Meantime, the average rate on a 30-year, fixed-rate mortgage fell seven-eighths of a point from the end of June to the beginning of December. Mortgage rates reversed field in mid-December and have climbed about a quarter of a percentage point since.

In its explanation for keeping rates steady, the Fed said there have been recent indicators of "somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market. Overall, the economy seems likely to expand at a moderate pace over coming quarters." That's a more optimistic assessment than the one the Fed gave on Dec. 12, when it mentioned a "substantial cooling of the housing market." The Fed is relieved at seeing some improvement in housing.

The central bank signaled that it's more likely to increase rates than to cut rates the next time it makes a move, whenever that is: "The Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information."

The phrase "additional firming" is Fedspeak for "rate increases." The Fed isn't saying for sure that it's going to raise rates. Many economists believe it won't touch rates at all this year. But the Fed is saying that an increase is more likely than a cut.

The fall and rise of long-term interest rates provides an insight into the thinking on Wall Street. For months, investors thought the Fed had gone a rate hike too far, and that the central bank would cut the federal funds rate in late 2006 or early 2007.

Wall Street had reached that conclusion even though Fed officials kept insisting that another rate hike was more likely than a rate cut because prices were rising too fast. To underscore the point, one member of the rate-setting committee, Jeffrey Lacker of the Federal Reserve Bank in Richmond, kept voting for another rate increase as the rest of the panel voted to stand pat. Lacker is not a member of the rate-setting panel this year because of the annual rotation of board members.

Wall Street satisfied
In December, investors appeared to decide that the economy was doing just fine after all, and that maybe the Fed was playing the game just right. Payrolls were growing, but not too rapidly, and the inflation rate was higher than the Fed's target, but was gradually slowing down. Even the news on house prices and inventory and construction looked vaguely promising if you squinted and looked at the data in a flattering light.

Wall Street was responding to "surprising strength in other economic numbers, without a doubt," says Chris Burdick, director of economic analysis for the Schwab Center for Investment Research in Denver. He adds that manufacturing indexes looked good, some housing numbers looked promising, and "you still have decent payroll growth. It's pretty hard to see chinks in the armor. Even the auto industry seems to be finding its legs here."

Two years ago, just six months after the Fed had embarked on its two-year rate-hike campaign, Burdick thought the central bank would soon pause. It didn't, and Burdick is convinced that the Fed has handled its mission deftly. "I think we have an economy that's set up for the soft landing," he says, because "they did not overshoot this time."

Nibbling increases
What's more, the Fed raised rates in little nibbles, resisting any urge to take bigger chomps. It increased a quarter of a point at a time. In previous cycles, the Fed sometimes raised or lowered rates a half-point at a time or even three-quarters of a point. The central bank has learned that it's better not to behave so aggressively, Burdick says.

He believes the Fed will hold short-term rates steady for the rest of this year and into 2008. That view is shared by the Mortgage Bankers Association's chief economist, Doug Duncan. But it's not unanimous. Economist Joel Naroff of Naroff Economic Advisors believes a cut is possible this summer. Jim Paulsen, chief investment strategist for Wells Capital Management, thinks an increase is more likely than a cut, although he's not making a prediction either way.

Banks charge the federal funds rate to one another for overnight loans. The Fed controls the federal funds rate indirectly, by selling and buying securities to add and subtract cash from the banking system. The prime rate is 3 percentage points higher, and moves up and down with the federal funds rate.