Fed leaves short-term rates alone, for now

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The Federal Reserve left short-term interest rates alone and said that the economy is at risk of heading south. That opens the door for another rate cut this year if the economy doesn’t improve.

The Fed’s rate-setting committee kept the federal funds rate at 1.25 percent. The prime rate will stay at 4.25 percent. Interest rates based upon the prime rate — those for certain credit cards, home equity loans and lines of credit, and auto loans — will remain where they are in most cases.

When the Fed’s rate-setting Open Market Committee meets, it usually gives its assessment of the economy. Last time, it said it didn’t have enough information to come up with an assessment because war was impending. This time, the Fed said the economy is in danger of cooling further.

“Recent readings on production and employment, though mostly reflecting decisions made before the conclusion of hostilities, have proven disappointing,” the Fed’s statement said. “However, the ebbing of geopolitical tensions has rolled back oil prices, bolstered consumer confidence, and strengthened debt and equity markets. These developments, along with the accommodative stance of monetary policy and ongoing growth in productivity, should foster an improving economic climate over time.”

The Fed has cut short-term interest rates 12 times since January 2001. It cuts rates when it senses that the economy needs a boost.

This has been a mixed-up, confusing economy for the past few months, but the picture is beginning to sort itself out now that the fighting in Iraq has ended without a disruption in the supply of Middle East oil.

When the Fed declined to give an economic assessment at its last meeting, on March 18, “that was unprecedented, that Alan Greenspan would acknowledge so much uncertainty in the Fed,” says Kenneth Thomas, a lecturer in finance at the Wharton School of Business. He compares it to former quarterback Dan Marino turning to the sideline for the play call, only to see the coach shrug as if to say, “I don’t know what to do.”

Although the Fed’s confession of confusion was unusual, it probably was the correct call, Thomas believes, “because the biggest economic event of the past year has been the uncertainty.” After all, the war was just days away.

Now there is less uncertainty and it’s easier to discern what’s going on with the economy. It’s a mixed picture, dominated by an ominous rise in unemployment. In April, the unemployment rate rose to 6 percent from 5.8 percent. The economy has shed 525,000 nonfarm jobs this year and more than 2.1 million jobs since a recession began in March 2001.

On the other hand, oil prices have fallen since March and consumer optimism is up.

Greenspan, speaking to a House panel last week, said “the fundamental trends shaping the economic outlook should emerge more clearly” now that the smoke is clearing in Iraq. He said he expects the economy to expand faster this year than last.

More importantly, Greenspan implied that he thinks it’s Congress’s turn to grease the economic skids by stimulating the economy with the president’s proposed tax cuts. There are two ways to stimulate the economy: The Fed can cut interest rates, or Congress can add money to the system by spending more or taxing less. The Fed doesn’t have much room to cut rates because they’re so low already, and that puts the ball in Congress’s court.

Even as Greenspan ponders rising unemployent and challenges Congress to stimulate the economy, he has to keep an eye on inflation, too. And he has to keep his other eye on the opposite problem — deflation.

“Although the timing and extent of that improvement remain uncertain, the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal,” the Fed said. “In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. The Committee believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future.”

Although Greenspan told Congress that he stands ready to battle deflation, the real problem could be inflation. In the first three months of this year, the prices that manufacturers pay for finished goods rose at an annual rate of 4.6 percent — and that’s after taking out the volatile food and energy components.

“I think that would be a source of worry if anything like that continued into the present quarter,” says George M. von Furstenberg, professor of economics at Indiana University in Bloomington.

“It would be very prudent for them to indicate that they will watch the inflation numbers very carefully henceforth, and remind the market that inflation is the dragon you have to slay anew every year or so,” von Furstenberg adds.

On the other hand, he adds, the rise in unemployment indicates that “there’s no indication that the second quarter will be a barn burner.”

“We truly are at a fairly uncertain juncture,” von Furstenberg concludes. No one can predict the size of the upcoming tax cut, inflation might be lurking, and the aftermath of the war in Iraq remains a question mark. The outcome will become clearer as May moves into June.

The federal funds rate is what Fed-member banks charge one another for overnight loans. It also is known as the overnight rate. The Federal Reserve sets a target for the overnight rate and controls it indirectly by adding and subtracting cash from the banking system.

The prime rate, which is what banks charge to their biggest customers, is 3 percentage points higher than the overnight rate.

Long-term mortgage rates don’t necessarily follow changes in the federal funds rate. Instead, mortgage rates tend to move in the same direction as yields on Treasury notes, which in turn move up and down according to investors’ economic outlook.

The committee’s next meeting is scheduled for June 24-25.