Fed holds rates for 7th time

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Monetary policy used to be interest-rate policy. That changed a year ago, and the Federal Reserve is demonstrating it now.

As expected, the Federal Open Market Committee announced today that it will keep its target for the federal funds rate between zero percent and 0.25 percent. Banks make overnight loans to one another at the federal funds rate, which has been near zero percent since mid-December. The federal funds rate influences other short-term rates, including variable-rate credit cards.

The Fed’s other monetary policy tools include its plan to buy more than trillion dollars’ worth of mortgage and government debt. Many observers wanted the central bank to clarify how it plans to wind up that shopping spree. They got the clarification that they wanted. The Fed said it will finish buying $1.25 trillion in mortgage-backed securities by the end of March. It reiterated that it will finish buying $300 billion worth of Treasury securities by the end of October.

Central bankers found themselves buying mortgage and government debt when they ran out of rate to cut. Just two years ago, the federal funds rate was 4.75 percent. The Fed slashed the rate last year to try to counteract the recession and the financial crisis, finally bottoming out last December with a federal funds rate near zero. When the federal funds rate was 4.75 percent, the Fed had a lot of room to drop rates. Now, with the rate near zero percent, there is no room to drop rates further.

Having used up all of its interest-rate leverage, the Fed fashioned some new tools. Among these new methods of stimulating the economy were the Fed’s plan to buy more than a trillion dollars’ worth of mortgage-backed securities, and another plan to buy hundreds of billions of dollars in Treasury notes. Both shopping sprees have the effect of keeping interest rates low. The intention is to encourage people to buy houses and refinance their mortgages, and for consumers and businesses to borrow and spend, boosting economic activity.

Will Fed keeping buying securities?

So there was some drama to this meeting of the Fed’s rate-setting committee: Investors and analysts were wondering what the Fed would say about its mortgage- and Treasury-buying programs.

Regarding the purchases of mortgage-backed securities, the Fed said it “will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010.”

Implicitly, that gives homebuyers and homeowners an incentive to borrow sooner rather than later. The Fed has kept mortgage rates low by buying mortgage-backed securities; when the Fed stops buying them, mortgage rates might rise. It’s not a certainty, because a lot of economic factors affect mortgage rates. But it’s a fairly safe bet to expect mortgage rates to rise as the Fed slows down its purchases of mortgage debt.

“When they do take action, many homeowners who have been trying to time the mortgage market in hopes of a lower payment will likely find themselves facing higher mortgage rates,” says Bill Emerson, CEO of Quicken Loans.

Craig Thomas, senior economist for PNC Financial Services Group in Pittsburgh, says he was hoping for the clarity that the Fed provided.

“Rates could very well be the last thing to move,” Thomas says. “If you think about the way the Fed is contributing to the credit markets — to general financial liquidity through all the special programs that they have had running for the last several quarters — the rates are almost secondary to what they’re doing.”

He thinks the Fed might wind up all those special programs first, and then raise rates after the jobs picture improves and “maybe a little indication that inflation is bubbling up.”

Lawrence Yun, chief economist for the National Association of Realtors, predicts that the Fed won’t raise the federal funds rate until at least the middle of next year. He says it’s important that the Fed “will continue to support the mortgage market until the housing market is on a sustainable recovery.”

In normal times, the Fed moves its target for the federal funds rate up and down in reaction to economic tides. When inflation got uncomfortably high, the Fed raised rates. When inflation was low and unemployment was rising, the Fed dropped rates. That was how the Fed conducted monetary policy. After the economy recovers, that’s probably how the Fed will conduct monetary policy again.

In the meantime, the Fed will coordinate with the Treasury to maintain low interest rates and to keep enough money in the financial system to prevent it from locking up. That constitutes monetary policy nowadays, and it probably will stay that way until sometime in the second half of next year.

The Fed’s next monetary policy meeting is Nov. 3-4.