Fed will stand pat and wait for Congress to act

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Everyone agrees that the economy needs a boost, but the Federal Reserve isn’t expected to provide it when the Federal Open Market Committee makes its announcement today.

The Fed’s rate-setting committee will keep short-term interest rates unchanged and wait for Congress to adopt an economic stimulus program this spring or summer. Another reason for the Fed to sit tight: uncertainty about Iraq and North Korea.

There’s yet another reason for the Fed to stand pat: It already has added a lot of stimulus to the economy. It cut short-term interest rates 11 times in 2001 and once in 2002 — “arguably the most aggressive series of policy easings taken to cushion a softening economy in the Fed’s history,” said Alfred Broaddus, president of the Federal Reserve Bank of Richmond and a member of the rate-setting committee, in a speech this month before the American Finance Association.

When the Fed started cutting short-term rates, the federal funds rate was 6.5 percent. Now it’s 1.25 percent, well below the 2.4 percent inflation rate in 2002 as measured in the consumer price index.

The federal funds rate, also known as the overnight lending rate, is what Fed-member banks charge one another for overnight loans. Other interest rates, most notably the prime rate, move in lock step with the federal funds rate. The rates on some types of consumer debt — auto loans, variable-rate credit cards, home equity loans and home equity lines of credit — are based on the prime rate.

Consumers kept spending through the 2001 recession and since. The recession and the weak recovery can be attributed to the unwillingness of businesses to hire employees and invest in factories and equipment. Thus the need for a government stimulus.

There are two main ways the government can stimulate the economy. First, it can lower interest rates, encouraging consumers and businesses to borrow and spend. That’s called monetary policy, and it is what the Fed has been doing for two years.

Second, the government can stimulate the economy by spending more — waging war, sending men to the moon, building ornate lodges in national parks, erecting hydroelectric dams, hiring baggage screeners at airports and myriad other things. That’s fiscal policy. Economists and investors believe the Fed will keep short-term interest rates steady while Congress adopts a more vigorous fiscal policy.

The Fed, says Keith Stock, global vice president for Cap Gemini Ernst & Young’s financial services sector, “has kicked the ball into the stimulus court.” In other words, the Federal Open Market Committee has signaled to Congress and the Bush Administration that it’s their turn to stimulate the economy. “I would expect the Fed to stand by and see how that pans out,” Stock says.

Stock is with the vast majority of economists and investors who expect the Fed to stand pat. The Chicago Board of Trade is pricing in just an 8 percent probability that the Fed will cut the federal funds rate to 1 percent.

With hardly anyone predicting a cut in short-term rates, the only drama at this Fed meeting lies in the committee’s assessment of the economy. At each meeting, the Open Market Committee delivers its view of the “balance of risks.” It announces whether the rate-setting body believes the economy is at risk of inflation or of economic weakness, or whether the risks are balanced.

When it last met, the committee said the risks are balanced between inflation and economic weakness. Stock believes the Fed will be reluctant to change that assessment until the situation with Iraq is resolved.