Fed is expected to hold rates steady

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The Federal Reserve is expected to keep short-term rates steady when its rate-setting committee meets May 6.

“They’re in an uncertain situation where it’s not clear that an interest-rate move would have any impact,” says Stephen Buser, finance professor emeritus from Ohio State University.

Fed chairman Alan Greenspan said as much in testimony this week before a House committee. Six weeks after the beginning of the war in Iraq, he told Congress, “We have only limited readings on broader economic conditions, and that information has been mixed.”

Consumers, he noted, show more optimism than business executives, and “the persistent high level of new claims for unemployment insurance suggests that firms may still be finding it possible to meet their customers’ tepid increases in demand with a leaner workforce.”

In that exquisitely polished phrase, Greenspan neatly sums up the problems facing the economy: More jobs are being lost than created, consumers aren’t buying enough stuff to pull the economy out of the ditch, and businesses have responded by working their employees harder when they’re not laying them off.

The dreary state of the economy comes despite the lowest short-term interest rates in more than 40 years. The federal funds rate, which is what member banks charge one another for overnight loans, stands at 1.25 percent.

The Federal Open Market Committee will decide May 6 whether to keep the federal funds rate at its current level or cut it another quarter-point. Most economists don’t expect a rate cut at this meeting. The Chicago Board of Trade has priced in a 30 percent probability that the Fed will cut the federal funds rate by a quarter-point.

Everyone acknowledges that more business investment would boost employment, and greater employment would boost business investment. When Greenspan says that it’s difficult to determine whether an interest-rate cut would set that cycle in motion, he is serving the ball into Congress’s court. He is waiting for Congress to act on the president’s tax-reduction proposal.

The president says that cutting federal taxes by $550 billion over the next 10 years, mostly by eliminating individuals’ taxes on dividends, would create 1.4 million jobs by next Election Day. That would go quite a ways toward recovering the 1.7 million nonfarm jobs that have disappeared since the president’s first tax cut in June 2001.

The House and Senate have shown a preference for smaller tax cuts. That dismays Keith Stock, global vice president for Cap Gemini Ernst & Young’s financial services sector. He would like to see the president’s entire tax-cut proposal become law. A smaller package, he says, “is not going to provide the extent of insurance coverage that we need to make sure the economy accelerates into recovery.

“We need to see some stimulus, either out of the Fed or out of Congress,” Stock adds, “and I think the Fed will keep its powder dry until it sees what comes out of Congress.”

Buser, the retired finance professor at Ohio State, arrives at the same conclusion as Stock: that the Fed won’t cut rates this time. But Buser adheres to different economic assumptions. The way to stimulate the economy now, he says, is for local, state and federal governments to spend. If governments repave highways, build new schools and buy more buses, more people will have jobs and the business climate will improve.

“The economy needs a kick in the rear from time to time,” Buser says. The most efficient way to deliver the necessary kick is for governments to create jobs, he says; cutting taxes or reducing short-term interest rates isn’t as effective in the short term.

“Our economy is not credit-constrained right now,” Buser says, because rates are so low. “You walk in the bank and the bank is very happy to see you coming.” So there’s little point in cutting short-term rates.

The Open Market Committee meets eight times a year. Its next meeting is scheduled for June 24 and 25.