Fed keeps rates low so recovery won’t slow

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Those looking for a loan can borrow with little sorrow, at least for now.

But the pain remains the same for savers.

So decrees the Federal Reserve’s rate-setting Open Market Committee, or FOMC. Concluding its meeting today, the FOMC issued the anticipated announcement that it would keep short-term interest rates at their current target rate of close to zero percent.

The FOMC statement suggested it will keep rates low for the foreseeable future. The statement said economic conditions “are likely to warrant exceptionally low levels for the federal funds rate for an extended period.”

In addition, in a separate effort to put downward pressure on interest rates, the FOMC voted to continue its “QE2” program. Designed to pump cash into the American banking system through a process known as quantitative easing, “QE2” theoretically will induce lending that, in turn, leads to business expansion and job creation.

The tepid recovery gave the Fed little choice but to stay the course on low rates and “QE2,” says Lyle Gramley, a Federal Reserve governor from 1980-85 and current senior economic adviser at Potomac Research Group.

“We still have an unemployment rate of 8.8 percent and a significant slowdown in growth in the first quarter,” says Gramley. “So this is not an environment that requires the Fed to start tightening monetary policy now.”

According to the press release, “the Committee will regularly review the size and composition of its securities holdings in light of incoming information and is prepared to adjust those holdings as needed to best foster maximum employment and price stability.”

When the Fed does decide to adjust holdings, the effect will be one of contraction as opposed to the expansionary policy of purchasing assets. A question for the future may be: Will the Fed adjust its balance sheet before turning to the option of raising interest rates?

While the Fed didn’t alter monetary policies, it did break with tradition in one significant way: After today’s FOMC meeting, Fed Chairman Ben Bernanke held a press conference, an abrupt departure from his media-adverse predecessor Alan Greenspan. Bernanke says he plans to hold four press conferences per year.

Choppy waters for savers

Experts said the vote to keep the so-called federal funds rate between zero and 0.25 percent — where it has been since December 2008 — should mean little change for consumers. But that isn’t a good thing for many households, says Bill Hampel, chief economist for the Credit Union National Association. Yields on savings products will remain at historic lows.

“Those consumers who save, which is a big chunk of consumers, especially older households, are still not going to see any relief from this week’s (Federal) Open Market Committee meeting on the really paltry yields they’re getting on savings account,” says Hampel.

For borrowers, the cost of loans will remain low. The prime rate, the benchmark to which many loans are tied, is always 3 percent above the federal funds rate. Traditionally, the Fed lowers interest rates to induce economic activity after a recession. But with rates already near zero, that is no longer an option.

‘QE2’ sails forward

The inability to cut rates any lower resulted in the Fed’s “QE2” program late last year. “QE2” stands for the second round of quantitative easing; “QE1” occurred between 2008 and 2010.

With quantitative easing, the Fed purchases large quantities of U.S. Treasury securities from banks. That, in turn, provides banks a stockpile of capital. The idea is that banks will be so brimming with cash they’ll step up their lending.

There has been periodic speculation the Fed would end “QE2” prematurely, but with an expiration date in June, it made no sense for the Fed to back off at this stage, says Mark Thoma, professor of economics at the University of Oregon. “The Fed believes that it’s best to keep its word unless significant circumstances force it off its announced path,” says Thoma.

Storm warnings?

In fact, some recent significant circumstances have likely heightened the Fed’s concerns. Most notably, gas prices are soaring, putting an already-weak recovery further at risk.

“The Fed is very concerned about oil at $112 a barrel,” says Greg McBride, CFA, Bankrate’s senior financial analyst. “It’s given them more ammunition for this wait-and-see attitude with regard to the economy.”

Energy prices aren’t the only fly in the economic ointment. The raging debate in Washington, D.C., over the federal budget deficit and whether Congress should raise the debt ceiling could potentially derail any progress the economy has made coming out of the recession, Gramley says.

“There are two choices if the debt ceiling is not raised,” he says. “One is to default on debt, which would have an enormously negative effect on interest rates through the foreseeable future, for the next 30 years or so.”

The other alternative is avert default by rapidly cutting government spending until it falls below federal revenue. The problem: “You (would) have to cut expenditures by $100 billion a month, or an annual rate of $1.2 trillion,” Gramley says. That’s roughly 8 percent of U.S. gross domestic product. “Go on with that for several months and we will see the biggest decline of economic activity in this country that we’ve seen since 1929,” he says.

A Congressional vote on raising the debt ceiling is expected in the next couple of months.

A wave of inflation?

If the Fed has some breathing room, it’s that so-called core inflation — stripped of volatile energy and food prices — remains quite low. It’s up 1.2 percent over the last 12 months, according to the latest figures from the Bureau of Labor Statistics.

The difficulty will be if soaring prices of oil and other commodities — corn has doubled in the last year — begin pushing up prices across the economy, says Jeremy Siegel, the Russell E. Palmer Professor of Finance at the Wharton School at the University of Pennsylvania.

“Bernanke may be forced to raise interest rates as soon as this summer” if core inflation starts to spiral upward, Siegel says. Historically, raising interest rates has been one of the Fed’s most powerful tools to fight inflation.

Janet Yellen, Federal Reserve vice chair and an FOMC voting member, said in a speech earlier this month that inflation isn’t an immediate threat, however. In Fed parlance, Yellen is generally considered an inflation “dove,” meaning she favors the current easy-money policies and considers inflation a relatively minimal concern.

“Increases in energy and food prices are, without doubt, creating significant hardships for many people, both here in the United States and abroad,” she told the Economic Club of New York. However, she added that “empirical analysis suggests that these developments, at least thus far, are unlikely to have persistent effects on consumer inflation or to derail the recovery.”

Yellen’s views were echoed by the FOMC’s statement Wednesday. “Inflation has picked up in recent months, but longer-term inflation expectations have remained stable and measures of underlying inflation are still subdued,” the FOMC statement said.