mortgage

Federal Reserve holds rates for 12th time

Federal Reserve building
Highlights
  • The Federal Open Market Committee maintained its target for the federal funds rate.
  • The federal funds rate influences the prime rate and other short-term rates.
  • The Fed has kept the federal funds rate near zero since December 2008.

The Federal Reserve kept short-term interest rates untouched today. As for long-term rates, it's hard to predict what the Fed plans to do, and whether the central bank is likely to succeed.

The Federal Open Market Committee kept its target for the federal funds rate at around zero percent. Banks make overnight loans to one another at the federal funds rate, which the Fed intends to keep within a range of zero percent and 0.25 percent. The federal funds rate influences the prime rate and other short-term rates, including those for variable-rate credit cards, HELOCs and shorter certificates of deposit. The Fed has kept the federal funds rate near zero since December 2008 to encourage consumers and businesses to borrow and spend to get the economy going.

The central bank said the economy is growing stronger, albeit slowly, and with little threat of inflation. It reiterated that it will keep short-term rates near zero for at least a few more months.

For the third meeting in a row, Thomas Hoenig voted against the policy action. Hoenig, president of Federal Reserve Bank of Kansas City, believed that the Fed will need to raise interest rates sooner than his colleagues think they'll need to be raised.

While critics sharpen their knives to critique the Fedsters' word choices, the central bank is trying to solve another conundrum: what to do about its vast holdings of excess bank reserves. We're talking more than a trillion dollars in Treasuries. On top of that, the Fed has bought more than $1 trillion of mortgage-backed securities.

When the Fed buys a dollar of Treasury debt from a bank, that's a dollar that the bank can lend. With excess dollars sloshing through the system, money is cheap and interest rates are low. The idea is to encourage consumers to buy cars and houses, keeping workers employed. Short-term rates recede.

"The federal funds rate target is playing less of an important role than in the past, prior to the crisis," says Cameron Findlay, chief economist for LendingTree. He says that by owning so much in Treasuries, the Fed is telling banks, "We want you to actually lend with that money."

Eventually, the Fed is going to shift into reverse. It will have to sell most of the Treasuries that it owns. When it does, dollars will be taken out of circulation. As less cash moves through the economy, money will be scarcer and therefore more expensive: Rates will rise on mortgages, car loans and certificates of deposit.

The Fed doesn't want to suck money out of circulation too soon, but it's not fully in control of its destiny, either. One factor is China, whose government owns huge amounts of Treasuries. If China were to start selling them, the effect would be the same as if the Fed were selling Treasuries: Long-term interest rates would rise -- and not necessarily on the Fed's preferred schedule.

"They (the Fed) are on an extraordinary high wire, trying to walk this tightrope at an unprecedented level," marvels Stephen Buser, finance professor emeritus at Ohio State University. In normal times, the Fed might own $1 billion in excess bank reserves; now it holds more than a thousand times that. Getting rid of it over time will be difficult without causing a debt crisis for the federal government or a credit crisis for businesses and consumers.

"They don't want to disturb credit and they don't want to disturb the Treasury auction," Buser says. "On the other hand, they've got this time bomb that's ticking, and everyone knows they have to back off."

In that context, the decision to keep the federal funds rate unchanged is straightforward. Tougher decisions lie ahead.

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