Fed may shift ‘bias,’ but not rates

At Bankrate we strive to help you make smarter financial decisions. While we adhere to strict , this post may contain references to products from our partners. Here’s an explanation for

The Patriots beat the Rams in the Super Bowl. Al Gore lost Tennessee. And the Fed could change short-term interest rates on March 19.

But don’t bet on it.

When the Fed’s rate-setting Open Market Committee meets in Washington, it is expected to keep the overnight lending rate at 1.75 percent. Banks would keep the prime rate at 4.75 percent.

The drama will focus on whether the central bank signals a change in which way it’s leaning in interest rate policy. Each time it meets, the rate-setting committee issues a short assessment of the economy that is commonly called the bias statement. There are three possible bias statements. You can think of them in terms of a stoplight.

When the Fed met in January, it left rates alone and said “the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future.” That’s the green light. It’s the Fed’s signal that it is leaning toward cutting rates again.

Many economists expect the Fed to change its economic assessment this time around to say that the risks are balanced between excessive inflation and economic weakness. That’s the yellow light, often referred to as a “neutral bias.” It signals that the Fed doesn’t plan to change short-term rates soon. If the Fed changes the light to yellow, it would indicate that it’s moving a step closer to raising interest rates this year.

Or the Fed could move from green to red without pausing at yellow. In that scenario, the committee would change its assessment to say that the risks are mainly toward excessive inflation. This “tightening bias” would hint that the Fed planned to raise rates at its next meeting, May 7.

Corey Redfield would prefer the Fed to go from green to red, but he doesn’t expect it to.

“If it were me sitting there, I think I would not necessarily raise rates, but I would think of tightening the bias to indicate that the next move is likely to be up,” says Redfield, chief fixed income strategist for U.S. Bancorp Piper Jaffray.

“I don’t think anyone expects the Fed to actually change rates,” Redfield says. “I expect them to go to a neutral bias. That’s kind of become the consensus view in the past week.”

It became the consensus view after March 14, when Fed Chairman Alan
Greenspan spoke to the Senate Banking Committee and said that a recovery from recession “is already well under way.” Just a week before, talking to a House committee, he had spoken of an “anticipated recovery.” What made him more optimistic in the intervening week was an economic report which implied that a year-and-a-half-long slump in manufacturing had ended.

In speeches during the past few weeks, Greenspan has noted that consumers continued spending during the recession, and that there is little pent-up demand to shove the economy out of the ditch and onto the road to recovery. He has openly worried that consumers will slow their spending just as manufacturing picks up. Right on cue, only a few days after the optimistic manufacturing report, February’s retail sales report was released — and it showed that consumer spending was up, but not as much as analysts had expected.

With that kind of mixed news, the Fed shouldn’t even hint of raising rates yet, says Michael Cosgrove, principal of The Econoclast, an economic analysis firm in Dallas.

“I expect them to effectively do nothing, and also I don’t think they should do anything at this point,” Cosgrove says. “Their bias is oriented toward ease at the present time, and I think they should probably remain that way.”

Cosgrove explains that the world economy is fragile and another Enron scandal could happen, “so I think the Federal Reserve would be well advised to do nothing” until the May 7 meeting. At that point the Fed could alter its bias to neutral and then be free to raise short-term interest rates this fall if oil prices continue to rise, he says.

Oil has risen from about $20 a barrel to $24 a barrel this year, a 20-percent increase. The price will rise further if an economic recovery takes hold, boosting demand for fuel, or if war in the Middle East disrupts supplies. Neither possibility is a long shot.

Even if the Fed changes its bias from green to yellow or red, that action in itself won’t have much effect on consumers. Short-term rates will remain about the same. Long-term rates, such as those for 15-year and 30-year mortgages, respond to trends in the overall economy.

Lately the overall economy has taken a modestly upward trend. According to Bankrate.com’s weekly mortgage survey, 30-year fixed rates have risen in the past month, from an average 6.92 percent to
7.06 percent. The average rate was 7.18 percent at the beginning of this year.

Last year, the Fed cut the overnight rate 11 times, lowering it from 6.5 percent at the beginning of 2001 to 1.75 percent, where it remains.

The overnight rate, officially called the federal funds rate, is what banks charge one another for short-term loans. The Fed sets a target for the overnight rate and controls it indirectly by adding and subtracting cash from the banking system.

The overnight rate influences the prime rate, which is what banks charge their best corporate customers. As a consumer, you won’t get a loan at the prime rate, but the rates you pay on some types of debt are based upon the prime rate. Many variable-rate credit cards, car loans and home equity lines of credit are tied to the prime rate.

The Chicago Board of Trade has priced in an 8-percent probability that the Fed will raise short-term rates a quarter-point on March 19. Traders have priced in a 90-percent chance that the Fed will raise rates a quarter-point at the May 7 meeting, and about a 75 percent chance that it will raise rates by another quarter-point at the June 25-26 meeting.

— Posted: March 15, 2002