In a dilemma, Fed stands pat on rates

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Short-term interest rates remain unchanged as honchos in the Federal Reserve try to figure out which is the greater danger: inflation or recession.

The central bank’s Federal Open Market Committee left the target for the federal funds rate at 2 percent, as expected. The prime rate will remain 5 percent. Most home equity lines of credit and variable-rate credit cards are based on the prime rate, and their rates will not change.

The rate-setting committee meets eight times a year. In the previous seven meetings dating back to last summer, the panel cut rates. The reduction in the federal funds rate was unusually rapid, going from 5.25 percent in September to 2 percent in April, as the Fed fought off a credit crunch.

With the economy in a slump, and with prices rising rapidly, the Fed has found itself in a dilemma. Short-term rates already are low, and if the central bank cuts them more to stimulate economic growth, then prices could rise even faster and get out of control. If the Fed raises short-term rates, the result could be a recession (or a deeper recession, if the economy already is in one) and a delayed recovery.

All this in an election year.

Fed stands pat

The Federal Reserve decided to keep the key interest rate the same after its meeting June 25.

The central bank’s least-bad option was to leave rates alone and keep an eye on prices and employment. That’s what the Fed did at this week’s meeting, at the risk of knowing in hindsight that it should have moved rates up or down instead.

“The Committee expects inflation to moderate later this year and next year. However, in light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remains high,” the Fed said in its statement.

The Fed didn’t have much of a choice, says Moe Ansari, president of Compak Asset Management in Irvine, Calif.

“The economy is getting worse, not better,” Ansari says. “The economy cannot handle interest-rate increases. On the other hand, inflation pressure is going up. They’re stuck between inflation and recession.”

In May, the Consumer Price Index rose 0.6 percent from the previous month, and was up 4.2 percent over the previous May. Prices not only are rising faster than the Fed would like, but the rate of increase is accelerating. The inflation rate is lower (0.2 percent in one month and 2.3 percent in 12 months) when you don’t count food and energy prices, which is better news for people who don’t eat, use electricity or refuel cars.

Prices for commodities, especially oil, have risen ferociously in the last year through some combination of demand, speculation and a weakening dollar. In normal times, the Fed doesn’t concern itself with any of those factors, but lately the central bank has trod onto the Treasury Department’s territory by speaking out about exchange rates.

At a conference in early June that was attended by his European and Japanese counterparts, Fed Chairman Ben Bernanke said: “We are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations and will continue to formulate policy to guard against risks to both parts of our dual mandate.”

Long story short, Bernanke wants a stronger dollar, which would break the rise in oil prices. How do you get a stronger dollar? Raise interest rates.

“My sense is they would like to raise rates,” says Tom Hepner, an analyst with Ruggie Wealth Management in Tavares, Fla. “They’d like to act a little more independently in a stronger-dollar policy mode.”

The Bush administration has paid lip service to the benefits of a stronger dollar, Hepner says, but the European Central Bank is likely to raise rates — a move that would have the indirect result of keeping oil prices high in the United States.

The problem with raising short-term rates is that it would have an unpredictable effect on long-term rates, including those for mortgages. A higher federal funds rate could result in higher interest rates across the board. But it’s also possible that a higher federal funds rate would reduce inflation expectations — and that could bring mortgage rates down.

With housing in a slump, mortgage rates could use some help. “I think the solution is we need to find a way to get these fixed rates lower,” says Steve Habetz, owner of Threshold Mortgage, a brokerage in Westport, Conn.

He says he almost wishes the Fed would raise rates, because it would prod fence-sitters into buying houses while, at the same time, countering inflation.

Habetz almost wishes for a Fed rate hike, but not quite. For the time being, he would be satisfied with anti-inflation talk from Fed officials, plus some creativity. He would like the central bank to buy mortgage-backed securities from Fannie Mae and Freddie Mac. If it bought enough securities, mortgage rates would go down. But the Fed would own investments that could lose value.

That brings the subject to the credit crunch that began in subprime mortgages in early 2007, spread to jumbo mortgages last August, and is moving into construction and development loans now. Maybe that will be an end of it, or maybe there will be a crunch in credit cards next. This fear that “the backside of the storm could hit us in the fall,” in Ansari’s words, might force the Fed to keep rates steady for the rest of the year.

Hepner thinks it will be next year before the Fed raises rates. “I believe personally that we’re in a more extended kind of crablike market that’s going to go down and waddle sideways, and we’re continuing to have more shoes drop as far as the financial markets are concerned.”

The federal funds rate is the target interest rate for banks borrowing reserves among themselves. The discount rate is the interest rate that the Fed charges banks to borrow reserves from the Federal Reserve. The Fed wants to be the lender of last resort: It wants banks to borrow from one another at the federal funds rate before borrowing from the Federal Reserve at the higher discount rate.