Fed holds rates for 8th time

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With a fragile recovery in its infancy, the Federal Reserve doesn’t want to make the economy walk while it’s learning to crawl.

So the Fed’s rate-setting Federal Open Market Committee made few changes in the wording of its rate policy statement. The next increase in the federal funds rate is a baby step that’s still months away. In the meantime, the Fed will slowly wean markets from their dependence on the central bank’s role as a primary buyer of mortgage debt and lender of last resort.

The Fed announced today that it will keep its target for the federal funds rate between zero percent and 0.25 percent. Banks make overnight loans to one another at the federal funds rate, which has been near zero for 11 months. The federal funds rate influences other short-term interest rates, including those of variable-rate credit cards.

The rate-setting panel said that it expects to keep the federal funds rate near zero percent “for an extended period.” Most observers interpret “extended period” to mean sometime in the second half of next year, at the earliest. The committee said it “continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

There was little change in wording from the previous rate policy statement, in September. The Fed said it will buy $175 billion in Fannie Mae and Freddie Mac debt, instead of the previously estimated $200 billion. The lesser amount is due to the fact that Fannie and Freddie don’t need to borrow as much as previously thought, the Fed said.

Last December, when the Fed cut the federal funds rate to nearly zero, the central bank found creative ways to keep pouring money into the economy to stimulate lending. One tactic was to promise to buy $1.25 trillion in mortgage-backed securities, a move that has kept mortgage rates low.

Winding down purchases

The last time the Fed met, in late September, it announced that it would gradually wind down the mortgage-buying program by the end of March 2010. Many lenders and economists believe that mortgage rates will rise as the Fed tapers off its purchases of mortgage-backed securities.

Meanwhile, Fed officials say they are confident that the economy is improving, but is far from thriving. “This turnaround is certainly welcome, but it should not be overstated,” Fed Governor Daniel K. Tarullo said in a speech in Phoenix last month. “Although we can expect positive growth to continue beyond the third quarter, economic activity remains relatively weak.”

Later in the same speech, he described the employment situation as “dismal.” Tarullo is a voting member of the rate-setting committee, and his words send a signal that the Fed isn’t eager to declare victory yet.

Until last year’s financial crisis, the Fed’s chief tool of monetary policy was the federal funds rate. When inflation got too high, the Fed would raise rates to discourage lending and cool the economy. When inflation got too low and unemployment rose, the Fed would cut the federal funds rate to encourage borrowing and stimulate the economy.

When the Fed cut the federal funds rate to near zero last December, it couldn’t cut the rate anymore. But Fed officials still saw a need to inject cash into the economy. So the central bank got creative and broadened its base of borrowers. Instead of lending only to member banks, it began to lend directly to businesses by buying commercial paper and other forms of debt. Then it began to indirectly lend to homebuyers and the federal government by buying mortgage-backed securities and U.S. Treasury debt.

The Fed’s vice chairman, Donald L. Kohn, said in a speech Sept. 30 that the central bank might start raising the federal funds rate before it winds down all of those lending programs. He said any such moves will be communicated well in advance.

“Around January or February, I think they’ll start to look very, very closely at how they might be evaluating their comments toward alerting people about the potential for raising rates,” says Cameron Findlay, chief economist for Lending Tree. “They can’t wait till inflation hits.”

The consensus among economists is that the next increase in the federal funds rate will happen in the second half of 2010.

The Fed’s next monetary policy meeting is Dec. 16.