Fed benches itself, won’t change rates

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Wall Street is certain that the Federal Reserve will keep short-term interest rates unchanged when the rate-setting committee meets Jan. 27 and 28.

That certainty is most clearly expressed in Chicago, far from New York’s Wall Street. The Chicago Board of Trade’s futures market has priced in a 100 percent chance that the federal funds rate, also known as the overnight rate, will remain 1 percent, where it has been since June. Observers believe it is likely to stay at 1 percent for months. “The Fed will remain on the sidelines until late 2004,” predicts Doug Duncan, chief economist for the Mortgage Bankers Association.

How the Fed affects rates
The prime rate, which moves in lock step with the federal funds rate, will remain at 4 percent. Rates for many auto loans, credit cards and home equity lines of credit are pegged to the prime rate, and they will remain largely unchanged.

Rates for 15- and 30-year mortgages don’t respond directly to short-term rates. Instead, they move up and down with 10-year Treasury yields, which in turn move up and down with Wall Street’s view of the broader economic outlook. The disappointing employment report for December, in which the government estimated that the economy produced just 1,000 new jobs that month, caused Treasury yields and mortgage rates to drop, even as short-term rates remained the same.

Members of the Fed’s rate-setting Open Market Committee have hinted for months that they don’t plan to raise rates for a while. In its post-meeting statements, the committee has been saying since August that it can keep rates low “for a considerable period.” That has been interpreted as meaning that the Fed will raise short-term rates eventually, but only after dropping obvious hints for a few months.

How the Fed drops hints
Those hints will come in two forums: in Fed officials’ speeches and congressional testimony, and in changes in the wording of the post-meeting statements. So far, the speeches have not suggested an increase in interest rates anytime soon.

Rates are low because inflation is low, which comes in response to rapidly improving worker productivity. Fed officials keep hammering this point, and Roger Ferguson, vice chairman of the Fed, even gave a
lengthy speech this month about the history of past productivity booms and what it means for the current one.

Some economists point out that the federal budget deficit is projected to reach $500 billion this year and get even bigger in the future. Theoretically, that could “crowd out” credit availability, causing interest rates to rise. The Fed has signaled that it won’t raise short-term interest rates in response to budget deficits.

Not my job
Donald Kohn, a member of the Federal Open Market Committee, said in a speech this month that the government deficits are “worrisome,” and that it’s a problem for Congress and the executive branch to fix by bringing taxes and spending more closely in line. “This is not a task for monetary policy,” he said. The Fed is in charge of monetary policy.

“Our manipulation of the overnight interest rate helps to keep the overall economy in balance — promoting price stability and production at the economy’s potential,” Kohn said. “Promoting savings is a job for fiscal and tax policy.”

The Fed could promote savings by raising interest rates. But Kohn said that’s not the Fed’s job. He wouldn’t say if his colleagues disagreed.