Fed leaves interest rates unchanged

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Meeting today amid a veritable hailstorm of dismal economic developments, the Federal Reserve’s Open Market Committee, or FOMC, opted to leave short-term interest rates at rock-bottom levels once again.

For the first time ever, the FOMC rate announcement contained a specific date at which interest rates could be raised. It’s a clear departure from the usual “extended period” language the markets have come to expect.

“The Committee currently anticipates that economic conditions — including low rates of resource utilization and a subdued outlook for inflation over the medium run — are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013,” according to the press release.

Not surprisingly the announcement also acknowledged that growth this year has been slower than expected.

The August meeting follows several economic reports indicating increasingly slow growth in the U.S., notably the release of the second quarter gross domestic product, which pegged growth from April through June at an annualized rate of 1.3 percent — one-third the level projected by the Fed in January.

The decision took place during an unnerving week in which the stock market saw the biggest one-day loss since 2008, following the historic downgrade of the nation’s credit rating by Standard & Poor’s late Friday afternoon.

The FOMC statement indicated that inflation may not rise above comfortable levels and acknowledged the fragile state of the economy. Both indicators hint that more quantitative easing from the Fed could be available in the future.

The Fed will continue to reinvest principal payments from securities already purchased under the asset purchasing programs and is “prepared to adjust those holdings as appropriate.”

Economy weaker than expected

As recently as the last FOMC meeting in June, economic policy was predicated on the belief that the problems plaguing the economy were transient in nature. Rising inflation and slower-than-anticipated growth were attributed to disruptions to the auto supply chain as a result of the earthquake in Japan, skyrocketing oil prices and bad weather throughout the spring.

However, “the latest numbers we’ve received suggest that the weakness in the economy is much more broad-based, probably not just a temporary factor as we believed for quite some time,” says Adolfo Laurenti, deputy chief economist at Mesirow Financial in Chicago. “There is something more structural at play.”

Former Federal Reserve governor Lyle Gramley agrees.

“The revision in GDP that we had with this last report was quite sobering. We had a significant downward revision in the first quarter GDP and the three-year revisions indicated that the recession was deeper than we thought it was. We had a very weak second quarter, and I think that indicates that the economy doesn’t have the kind of strength we thought we saw developing late last year,” he says.

Despite the dismaying labor market conditions, slower household spending and depressed housing sector, the FOMC did find a silver lining in the economy.

“Business investment in equipment and software continues to expand,” they reported in the press release.

What’s in store for consumers

Yield-starved savers will find no relief from the Fed’s ongoing interest rate policy. Rates on deposit products and fixed-income investments will remain extremely low. Borrowers may still benefit from the record-low rates.

However, loan rates may increase slightly as a result of the U.S. credit downgrade from triple-A to double-A-plus by Standard & Poor’s last week.

Though short-term interest rates as set by the Fed remain unchanged, “you could see credit card issuers boost rates, particularly for riskier borrowers. Car loan rates may move up a little bit and mortgages may give back a little of the big decline seen over the last few weeks. But that is small potatoes compared to the impact a recession would have,” says Greg McBride, CFA, Bankrate’s senior financial analyst.

At this point, another recession would be devastating to the U.S. economy. As painful as the yield drought is to savers, interest rate policy is dictated by the economy. Theoretically, ultra-low interest rates should encourage more borrowing and spending by businesses and individuals.

“The weak U.S. economy is not only the primary determinant of what is happening with interest rates, it’s also the main pocketbook issue for Americans,” McBride says.

“If we have another recession, a couple million Americans will lose their jobs and retirement accounts will take a further hit,” he says.

QE deja vu

The Federal Reserve has taken two stabs at economic stimulus previously. In 2008, the Fed announced plans to purchase bonds from government-sponsored enterprises along with mortgage-backed securities. The asset purchase plan was expanded in the spring of 2009 and purchases ended at the end of the first quarter in 2010.

In November 2010, the second round of quantitative easing, or QE2, was launched, in which $600 billion of Treasury securities were purchased through June 2011.

The main tool available to the Federal Reserve is the federal funds rate, or the short-term interest rates banks charge one another for borrowing overnight. With interest rates at virtually zero since December 2008, the only way the central bank can stimulate the economy will be through further asset purchases.

According to Gramley, the Fed’s options going forward include buying new securities to replace maturing securities bought under the asset purchasing program, extending the maturity of their holdings by replacing maturing securities with issues of longer maturity, or engaging in another round of quantitative easing.

The question is: How effective will any of those be?

“If I had to guess, I would say that any one of those things, or all of them put together, (is) going to add no more than a few tenths of a percentage point to growth next year. What we need are a couple of percentage points of growth — more than is likely to be in the cards,” says Gramley.

The FOMC will meet again Sept. 20, but an economic symposium in Jackson Hole, Wyo., is coming up in late August, at which more information on economic policy may be forthcoming.