Fed holds steady for 4th time

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Short-term interest rates will remain about where they are, at least for the next few weeks.

The Federal Reserve’s rate-setting committee left the federal funds rate unchanged today at 5.25 percent. The prime rate will remain at 8.25 percent. Rates won’t change on variable-rate credit cards and home equity lines of credit that are linked to the prime rate. Yields on shorter-term certificates of deposit will remain about the same.

The central bank started setting the table for rate cuts, possibly sometime next year.

“Economic growth has slowed over the course of the year, partly reflecting a substantial cooling of the housing market,” the Fed said in its statement. It had said almost exactly the same thing after the previous meeting, but this time it added the word “substantial.”

Yes, that’s how closely people read these things.

More significantly, the Fed added some weasel words in its assessment of the economy. The last time around, the central bank had asserted that the economy looked likely to expand at a moderate pace. This time, that sentence went like this: “Although recent indicators have been mixed, the economy seems likely to expand at a moderate pace on balance over coming quarters.”

In other words, the economy is sorta going well. Kinda. And on balance it looks like it’ll expand. Probably.

Some economists believe that such tentative wording is prelude to a more definitive change in the Fed’s assessment of the economy, followed by rate cuts.

While short-term rates will remain unchanged for now, it’s anyone’s guess what direction long-term interest rates will take. Rates on long-term debt, such as for fixed-rate mortgages, have fallen in the last half of the year as the economy cooled. That unexpected drop might even have been a boon to the Fed because it allowed the central bank to stand pat instead of cutting short-term rates immediately after raising them.

From the middle of 2004 until the end of this June — meeting roughly every six weeks — the Fed raised short-term rates 17 times in a row, by a quarter-point each time. At the end of June 2006, the rate on an overnight loan was roughly the same as the yield on a 10-year Treasury note. In other words, a bank could get the same interest rate on an overnight loan — which is what the federal funds rate is — to another bank as it could get on a 10-year loan to the federal government. Normally, rates are higher on longer-term loans.

Inverted yields
Since the end of June, the rate has plunged on that 10-year loan to the government, while the federal funds rate has stayed the same. That’s not normal. In fact, it’s downright strange, and it means that the rate on the overnight loan eventually will have to fall, or long-term rates will have to rise or a combination.

To put it another way, the overnight rate will have to drop from its current 5.25 percent, or the yield on the 10-year Treasury will have to rise from its current 4.5 percent, or both. Less than six months ago, the 10-year Treasury yielded 5.25 percent.

“If you had asked me six months ago would we be at a 10-year Treasury at 4.5 percent, I would have said ‘I don’t think so,'” says Bob Walters, chief economist for Quicken Loans. The three-quarters-of-a-point drop in the 10-year Treasury allowed the Fed to stand by instead of cutting the overnight rate, Walters says: “The Federal Reserve essentially let the bond market do their dirty work. They’re kind of sitting on the sidelines right now.”

Sitting on the sidelines, keeping the federal funds rate unchanged for the fourth meeting in a row.

“If long-term interest rates were rising, that would give the housing market a tough go, and the Fed would feel like they have to do something,” Walters says.

Housing downturn
House sales have been slumping and factory output has fallen. Those are two of the many factors behind the fall in long-term rates. When the economy slows down, inflation becomes less of a threat. And when inflation dies down, interest rates fall.

But, Fed officials have continued to talk about the prospect of unwelcome inflation. Meanwhile, falling bond yields send a signal that the bond market thinks an economic slowdown poses more of a threat than inflation.

“I think it’s kind of a little bit of a tug of war between a slowdown in the economy and inflationary pressures that are out there,” says Gary Wolfer, senior vice president and chief economist for Univest’s Wealth Management & Trust Division.

Inflation hawks are slowly losing ground in this tug of war, Wolfer says. Eventually, he says, the Fed will shift from its inflation-fighting mode and into a balanced stance, in which it will say that the prospects of inflation and recession are roughly equal. That will be the prelude to a rate cut.

Wolfer believes the Fed will cut rates two or three times next year, once next summer and once or twice in the fall.

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.