The Fed has changed its economic assessment, and it probably will raise short-term interest rates in early May or late June. Mortgage rates, which have been on the rise all year, won’t be affected much by the Fed’s action.
The Federal Reserve’s rate-setting committee kept the overnight lending rate at 1.75 percent in its March meeting. As expected, the open market committee did alter its economic assessment — what observers call the bias statement.
The committee said that the economy is expanding, but it’s uncertain how strong demand will be.
“In these circumstances, although the stance of monetary policy is currently accommodative, the committeee believes that, for the foreseeable future, against the the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are balanced with respect to the prospects for both goals,” the committee announced.
“It’s a recognition on the part of the Fed and (Fed Chairman Alan) Greenspan that the recovery is under way,” says Joel Naroff, economist for Naroff Economic Advisors in Holland, Pa. He expects the committee to start raising rates in June, although May is a possibility. The Fed’s statement implies that the committee isn’t in a particular hurry to raise rates.
For the past 15 months, all the Fed’s economic assessments said that the risks were weighted toward economic weakness. Those “easing” bias statements implied that the Fed was leaning toward cutting interest rates if necessary.
This time, the Fed adopted a neutral bias. Normally, a neutral bias implies that the Fed isn’t leaning either way on interest rates. But these aren’t normal times — the economy seems to be recovering from a mild recession — and observers interpret this change in bias to mean that the Fed is leaning toward raising short-term rates by early summer. The next two meetings are May 7 and June 25-26.
Bankers, investors, economists and bond traders were unsurprised by the Fed’s action. It was exactly what they expected, and interest rates had been set accordingly. As a result, the Fed’s action isn’t expected to have much of an immediate effect on interest rates.
“While they may have moved to an equal balance as far as risks go, the Fed is trying to walk a fine line,” Naroff says. “They don’t want to make it certain that they’re going to increase rates immediately; at the same time, they realize that’s a possibility. The move sets up the possibility, but does not necessarily tell us when they’re going to make the move.”
Naroff likens the overnight rate to the economy’s gas pedal; a rate lower than 4.5 percent is stepping on the gas.
“The stronger the economy gets, the more the Fed has to take the foot off the gas pedal,” Naroff says. “Right now the Fed is standing on the gas pedal with both feet, and it’s going to take time for them to take their feet off.”
When the rate-setting body starts raising rates again, Naroff expects it to take about a year to bring the overnight rate to 4.5 percent.
Greenspan hinted of the impending bias change early this month when he told a Senate panel that “recent evidence increasingly suggests that an economic expansion is already well under way.” That was a more optimistic assessment of the economy than he had offered just eight days before to a House committee. He apparently had been strongly influenced by an economic report that heralded the first manufacturing expansion in 19 months.
In his appearances before the House and Senate in late February and early March, Greenspan said he was optimistic about the economy’s long-term prospects. He said he worried that the recovery would be sluggish because consumers continued spending through the recession. Typically, consumers end recessions by going on a spending spree, but there is little pent-up demand this time.
The overnight rate, officially called the federal funds rate, is what banks charge to one another for short-term loans. The Fed sets a target for the overnight rate and controls it indirectly by adding and subtracting cash from the banking system.
The overnight rate influences the prime rate, which is what banks charge their best corporate customers. Some types of consumer debt are tied to the prime rate. Among them are variable-rate credit cards, car loans and home equity lines of credit.
The prime rate will remain at 4.75 percent because the Fed left the overnight rate alone, so most consumer debt based upon the prime rate will stay the same.
Interest on 15- and 30-year fixed-rate mortgages tends to move independently of the Fed’s rate actions. Long-term mortgage rates roughly follow the movements of 10-year Treasury notes, which in turn are influenced by economic expectations.
Positive economic news has mixed with negative news this year and mortgage rates have reflected that muddle. In Bankrate.com’s weekly index of large lenders, the national average 30-year mortgage rate began the year at 7.25 percent, moved fitfully to a low of 6.82 percent at the end of February, and rose to 7.06 percent as of March 14.
Ninety percent of the experts surveyed last week by Bankrate.com expect mortgage rates to rise or hold steady over the next five weeks or so.
The Fed kept the seldom-used discount rate at 1.25 percent. The discount rate is what the Fed charges banks to borrow reserves directly from the central bank.
The Fed’s open market committee schedules eight meetings a year. The most recent meeting, on Jan. 29 and 30, marked the first time in more than a year that the Fed hadn’t cut short-term rates. The Fed reduced rates 11 times in 2001, from 6.5 percent to 1.75 percent. Three of those cuts were made during telephone conference calls between scheduled meetings.
Futures traders at the Chicago Board of Trade have priced in a 96 percent probability of a 0.25 percent Fed rate increase at the May 7 meeting.