The Federal Reserve will have to remain patient, and so must investors, as the central bank waits to find out if it has fought inflation effectively.

The Fed’s rate-setting Open Market Committee left short-term interest rates alone today, as expected. The federal funds rate remains 5.25 percent and the prime rate stays at 8.25 percent.

Rates on variable-rate loans, such as those for home equity lines of credit and some credit cards, should remain about the same. The effect on other kinds of interest rates, such as those for fixed-rate mortgages and longer-term certificates of deposit, are hard to predict because those rates are set by markets and not by the Fed.

What the Fed said
The central bank said the economy has slowed this year, partly because the housing market has cooled. But inflation remains, and low unemployment could place upward pressure on prices. More rate hikes might be necessary, the rate-setting committee warned.

“However, inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations, and the cumulative effects of monetary policy actions and other factors restraining aggregate demand,” the Fed said in its explanatory statement.

Members of the rate-setting committee had fanned out far and wide in early October to warn investors that inflation was quite a bit higher than the Fed’s informal target of between 1 percent and 2 percent. The Fed’s favored measure of inflation, the core personal consumption expenditures price index (“Fed’s favored measure of inflation,” for short), was up 2.5 percent in the year ending in August. The core Consumer Price Index was up a more alarming 2.9 percent in the year ending in September.

On Oct. 4, Donald Kohn, vice chairman of the Fed, said in a speech that he believes interest rates will drop gradually, but “in the current circumstances, the upside risks to inflation are of greater concern.” That, in a nutshell, is what other members of the Fed said, too, in speeches around the same time. The strong implication was that the Fed would stand pat for a while on interest rates, but if the central bank did change rates, it would be to raise them, not to lower them.

So how did markets respond? By assuming that there was a tiny chance of a rate cut and virtually no chance of an increase. The federal funds futures market at the Chicago Board of Trade was pricing in a 98 percent probability of no rate change this week, and a 2 percent chance of a quarter-point cut.

Radar clear of rate cuts
“Lowering rates is not even on the radar screen,” says Lyle Gramley, senior economic adviser for Stanford Washington Research Group and a Fed governor from 1980 to 1985.

Gramley says he expects inflation to wane over the next year, but slowly. One reason: the way inflation is measured. The inflation rate doesn’t take house prices into account. Instead, it measures rents. And rents have been going up as vacancy rates have gone down. The supply of dwellings available for rent has been dropping because a lot of people were priced out of buying houses during the boom years of 2000 to 2005; meanwhile, owners of apartment buildings were converting the units to condominiums, which further reduced the supply of rental units.

Now that house prices are falling, the same could happen to rents eventually. But not immediately, because rents are locked in during leases.

By many indications, this is what the Fed wanted to happen when it started raising short-term interest rates in the middle of 2004. The Open Market Committee meets roughly every six weeks — eight times a year — and it raised rates a quarter-point at a time, 17 times in a row, until August’s meeting. The Fed’s first priority two and a half years ago was to burst the housing bubble. The bubble did deflate, and economists will debate for decades how much the Fed contributed to the bursting and how much was the inevitable result of market forces at work, regardless of the Fed’s actions.

Internal Fed debate
From afar, Gramley guesses that some members of the rate-setting committee have been advocating another rate increase, just to nail down inflation for sure. But, he predicted Tuesday, “cooler heads will prevail.” The minutes of this meeting will be released in about three weeks, and investors will have a clearer picture of the Fed’s internal debate then.

Keith Stock, president of MasterCard Advisors in Purchase, N.Y., says he thinks some members of the rate-setting committee are still concerned about inflation, but don’t want to rattle any cages. They’re thinking, “We’re still engineering a soft landing, let’s not do anything to surprise the markets,” Stock says.

He believes that’s the right way to go, but there’s still a lot to worry about. Prices for commodities such as wheat, corn and soybeans have been going up. With the economies of China and India growing, demand for lumber and other construction materials could keep rising, putting upward pressure on prices for those commodities. Stock says he expects the Fed to keep a close eye on these developments.

“The one disappointment,” Stock says, “is the ‘soft landing’ has been discernibly soft. In the past, we’ve experienced faster and more demonstrable increases and decreases. We’re not seeing that now.”

Banks charge the federal funds rate to one another for overnight loans. The Fed controls the federal funds rate indirectly, by selling and buying securities to add and subtract cash from the banking system. The prime rate is 3 percentage points higher, and moves up and down with the federal funds rate.