Fed forecast: Expect shifting words, but no rate change

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Today’s interest rate climate is like winter in Miami. It’s pleasant and you savor every minute of it, because things will heat up in a few months. You don’t know exactly when. But inevitably conditions will become oppressive and maybe stormy — something to endure and not enjoy.

The Federal Reserve’s rate-setting committee meets May 4. Few people expect the Fed’s Open Market Committee to raise interest rates this time, but everyone expects a rate increase this year. Investors will pore over the committee’s post-meeting statement as intently as an engaged couple reading the weather forecast before their outdoor wedding.

Observers will look for the presence or absence of words such as “patient” and “muted,” and phrases such as “probability of an unwelcome fall in inflation.” They will examine the committee’s statement in light of recent speeches by Fed officials. Then, like a meteorologist studying isobars and satellite photos, they will make forecasts.

Winds shifting
Economists and investors already have been revising their forecasts. Until a few weeks ago, most of them had predicted that the Fed wouldn’t raise rates until after November at the earliest. Then came the beginning of April, when the federal government reported that a net 308,000 jobs had been created in March. Since then, hints of gathering inflation and recent speeches by Fed officials have convinced Wall Street that the Fed will raise rates before November. The consensus is that the increase will come at the committee’s Aug. 10 meeting, and that the panel will pave the way for an eventual increase in its post-meeting statement on Tuesday.

“I think that they’re setting a tone for possible increases — but not at this meeting,” says Keith Stock, vice president of Cap Gemini Ernst & Young financial services. “So I think we’ll continue to see a concern expressed with regard to the sustainability of the economic recovery, and that it’s looking more positive.”

That’s somewhat of a mixed message — things are looking positive, but the sustainability of the recovery is in question — and Stock believes that would be the correct message to send because it wouldn’t be a surprise.

“One of their objectives is not to come forward with surprises unless they absolutely have to,” Stock says.

Alan Greenspan, chairman of the Fed, has said much the same thing, although not as clearly. In testimony to a congressional joint committee April 21, he all but guaranteed that no rate increase would be forthcoming in May. He said, “the federal funds rate must rise at some point to prevent pressures on price inflation from eventually emerging,” then added that low rates have not “fostered an environment in which broad-based inflation pressures appear to be building.”

Greenspan sent two messages with that statement. One message was what he said and the other consisted of why he said it. What he said was, to paraphrase, “We’ll raise rates, but not in May.” He said it to avoid surprising anyone. The implication is that the Fed will provide plenty of warning in the weeks before it finally raises rates.

It looks like that will happen in August. Futures traders on the Chicago Board of Trade have priced in a 100 percent chance that the Fed will raise short-term rates by one-quarter of a percentage point by the end of August, and a 56 percent chance that the Fed will raise it by half a percentage point by then. Traders have priced in a 6 percent chance that the Fed will raise rates by a quarter-point May 4 and a 12 percent chance of a quarter-point increase at the Fed’s June 29-30 meeting. There is no Fed meeting scheduled for July.

The Fed influences overall interest rates by indirectly controlling the federal funds rate. That rate, also called the overnight rate, is what banks charge one another for overnight loans to cover reserves. The federal funds rate has been 1 percent since June, when the Fed cut the rate for the 13th time in 30 months. The rate had not been that low since 1958.

Why the fed funds rate matters to consumers
Some other rates move up and down with the federal funds rate. Chief among them is the prime rate, which is 4 percent. Rates for some, but not all, home equity loans, equity lines of credit, auto loans and credit cards are based on the prime rate.

Long-term mortgage rates are influenced only indirectly by the Fed’s short-term rate moves. Mortgage rates are more closely related to U.S. Treasury yields, and move up and down with investors’ expectations about the economy.

At 1 percent, the federal funds rate is below the rate of inflation (1.7 percent in the last year), making overnight loans free. The Fed has set rates low as a way to stimulate the economy. The last few post-meeting statements have said that the rate-setting committee can be “patient” before raising rates. Greenspan, in appearances before two congressional committees in April, pointedly avoided saying the word “patient.”

Greenspan did say that the Fed “will act, as necessary,” to ensure that inflation remains low.

“It seems a decent possibility that a pledge to ‘act as necessary’ or something similar will replace the previous reference to ‘patient’ policy” in the May 4 post-meeting statement, wrote Merrill Lynch analysts Ted Wieseman and David Greenlaw in their preview of the Fed meeting.