Fed holds rates for 6th time

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With job security in mind, the Federal Reserve kept a key short-term interest rate near zero percent.

The Federal Open Market Committee kept its target for the federal funds rate between zero percent and 0.25 percent, as expected. Banks make overnight loans to one another at the federal funds rate, which has been near zero percent since mid-December. The federal funds rate influences other short-term rates, including variable-rate credit cards.

Short-term rates are drastically low because the Fed wants to encourage consumers and businesses to borrow and spend to boost the economy. With the federal funds rate near zero, the central bank doesn’t have room to cut rates anymore, so it has been goosing the economy in other ways — most notably, by keeping longer-term rates down through purchases of Treasury notes and home mortgages.

In its statement announcing that the federal funds rate will remain unchanged, the committee adopts a cheerier tone than in the previous statement in June. The new statement suggests that “economic activity is leveling out.” In the June statement, the Fed had said that “the pace of economic contraction is slowing.”

The difference between the two statements is remarkable. In June the Fed said that things are getting worse, but not as fast as before; now the Fed is saying that the worst seems to be behind us.

There is one other notable difference in this Fed statement: The committee says it will gradually wind up its purchases of Treasury securities and stop buying them in October. The Fed had said all along that it would stop buying Treasuries sometime in the fall; this is a way of announcing that the Fed has not changed its mind. The Fed has been flooding the economy with money through multiple spigots, and now it will shut off one of them gradually, as it had said it would.

The Fed is engaged in a balancing act. It strives to keep employment high and inflation low. Today’s low interest rates are intended to boost employment, but if rates stay too low for too long, excessive inflation could result. Eventually, the Fed will have to “tighten” rates — that is, raise them to keep inflation away.

How long will the rate stay low?

“The big question is when they are going to tighten up,” says Kenneth Thomas, lecturer in finance at the Wharton School at the University of Pennsylvania. “Some people are speculating before the end of the year. I do not see that.”

For months, the Fed has said that it will keep rates low for a “considerable period.” Thomas interprets that as meaning that it won’t raise rates until next year. “The Fed typically does not start raising rates until unemployment rates are coming down, or at least stabilized. We’re at the opposite end of that,” Thomas says.

And Thomas sees a more personal dimension: Fed Chairman Ben Bernanke’s term expires at the end of January. He can be reappointed by President Barack Obama — if the chief executive approves of his job performance.

Raising rates prematurely “is not a smart way to get a job,” Thomas says. “If you want to upset Obama, the way you do it is by bringing back rates before unemployment goes down.”

Future inflation?

Anthony Sanders, professor of finance at George Mason University, believes the Fed is (or should be) concerned about future inflation. Or, as he expresses it in a mixed metaphor: “The dreaded inflation dragon is humming in the air like a cholera epidemic.”

The prospect of runaway inflation in the future isn’t the only issue that the Fed faces, Sanders says. “Commercial mortgage defaults pose a second wave of credit-related problems to smack the financial sector,” he says. This problem particularly affects smaller community banks.

And productivity soared in the second quarter as employers cut workers’ hours but expected the same output. The productivity increase is “potentially good news for upcoming unemployment numbers,” Sanders says. A rate increase would have counteracted that good news, he believes.

Normally, the Fed sets a target for overnight rates and lets the market determine long-term interest rates, such as for mortgages. That has changed. Since March, the central bank has spent hundreds of billions of dollars to push down mortgage rates and long-term Treasury yields. Holding down long-term rates, and encouraging homeowners to free up some spending money by refinancing their mortgages, were seen as economy-boosters. Sanders says the Fed doesn’t want to tinker with that.

The Fed’s next rate-policy meeting is Sept. 22 to Sept. 23.

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