Fed slightly optimistic, somewhat divided

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Most members of the Federal Reserve’s rate-setting committee believe that the economy doesn’t need a boost from lower short-term interest rates. But that belief isn’t unanimous. Two of the committee’s 12 members think the Fed should cut rates.

The Federal Open Market Committee has kept the target for the federal funds rate at 1.75 percent. The federal funds rate, also known as the overnight rate, is what member banks pay one another for overnight loans.

The Sept. 24 decision to hold short-term rates steady means that consumer debt tied to the prime rate
some auto loans and credit cards, especially — is unlikely to drop in the next few weeks. Rates on 15- and 30-year mortgages won’t be affected much because they respond to broader economic factors.

Aggregate demand — the sum of all personal, business and government spending — “is growing at a moderate pace,” the committee says.

The Fed’s latest statement strikes a more optimistic tone than the one on Aug. 13, the last time the rate-setting committee met. Back then, it talked of the softening in the growth of demand because of weak financial markets and corporate scandals.

John Oakes, a fixed income trader with ABN AMRO Capital Markets Group, says investors and traders will “look at what the Fed says through a microscope, find out which way they’re leaning.”

Investors might peer through their microscopes for quite a while because the Fed’s most recent statement contains contradictions. Although the Fed says demand is growing moderately and a cut in interest rates is unwarranted, committee members Edward Gramlich and Robert McTeer voted to reduce the federal funds rate. The Fed doesn’t say by how much they want to cut the rate, but it’s probably by 25 basis points, to 1.5 percent.

Gramlich, a Federal Reserve Board governor, is considered a moderate on interest rate policy. McTeer, president of the Federal Reserve Bank of Dallas, has a reputation of being “dovish” on interest rates: He is considered more likely to be among the first to want to cut rates and among the last to want to raise them. In June, he said in a speech that the economy bore “some resemblance to the so-called jobless recovery after the 1990-91 recession.”

The Fed statement also hints of war with Iraq: “However, considerable uncertainty persists about the extent and timing of the expected pickup in production and employment owing in part to the emergence of heightened geopolitical risks.”

The decision is not a surprise. Two weeks before the rate-setting committee met, three Fed bank presidents made speeches in which they hinted that the economy is strengthening and doesn’t need any more rate cuts.

The economy got stuck in a recession last year, like a Jeep sunk in mud up to the fenders. The Fed tied a rope to the chassis
at the beginning of 2001 and commenced tugging. The first rate cut was like one man pulling on the rope. Then came another rate cut, and another. By year’s end, the Fed had cut short-term rates 11 times, from 6.5 percent to 1.75 percent. It was as if an 11-man football team were pulling on the rope.

It seemed to work. It takes a few months for Fed rate cuts to have their desired effect, and the economy grew quickly at the beginning of this year. But growth slowed from April to June. It was like the 11 men yanked the Jeep out of the deepest part of the bog, but they stumbled, and the vehicle got stuck again but not as badly. The pullers continue to make unsteady progress, and now some bystanders and even two Fed members wonder if a 12th man — another rate cut — is necessary.

No, the majority of the Fed says. Not yet.

With the federal funds rate at 1.75 percent (a 41-year low), the Fed doesn’t have much rope left. What if a 12th rate cut didn’t add enough oomph? That would be dispiriting. Or what if a 12th rate cut added too much oomph, freeing the economy from the bog but causing runaway inflation? Unlikely, but you can’t rule out the possibility.

The Fed says the risks are weighted mainly toward conditions that could generate economic weakness. That’s like saying a 12th man is warming up and will be called in if necessary. The rate-setting committee meets two more times this year — Nov. 6 and Dec. 10 — and some investors and economists believe the Fed will deploy a 12th rate cut at one of those meetings. The Chicago Board of Trade has priced in a 60 percent probability of a rate cut to 1.5 percent in November.

Some observers think another rate cut would send the wrong message: that the Fed is panicking. Another rate cut “just plays that fear spiral,” says Robert Weagley, an economics associate professor at the University of Missouri in Columbia. “The psychology of markets has as much to do with the direction markets go as fundamentals.” And the fundamentals of the economy — things such as business inventories and worker productivity — aren’t doing too bad, he says.

The federal funds rate is important to businesses and individuals because the prime rate is tied to it, moving up and down in lockstep with the federal funds rate. In turn, rates on some kinds of debt, such as credit cards, auto loans, and some home equity products, are tied to the prime rate. Right now, the prime rate is 4.75 percent. A year ago, it was 6 percent.

The Fed controls the federal funds rate indirectly by adding and subtracting cash in the banking system.

— Posted: Sept. 24, 2002