No rate change as Fed holds on for recovery

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A timeless bit of advice goes like this: When you find yourself in a hole, stop digging. Sagely, the Federal Reserve’s rate-setting body set aside its shovel.

The Fed’s Open Market Committee left its target for the federal funds rate at 1 percent, as expected. The prime rate will remain at 4 percent, and consumer rates based on the prime rate — those for some home equity loans, home equity lines of credit and auto loans — will remain where they are.

In a stab at clarity, the panel said explicitly that it doesn’t plan to raise short-term rates for “a considerable period.” The intention is to keep long-term rates from rising.

“The committee judges that, on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future,” the panel said in its policy statement. “In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.”

It said the risks of inflation and stagnation are “roughly equal,” and added that it continues to worry about “an unwelcome fall in inflation.” The Fed first expressed this worry in May.

The statement was more straightforward than usual. Wall Street wanted a lucid explanation of the Fed’s thinking this time, because investors had been confused by the central bank’s statements in the past three months:

  • In May, the Fed expressed concern over the effects of extremely low inflation. Bond traders started buying long-term Treasury notes in hopes that the Fed later would have to buy them at inflated prices. In effect, bond traders crawled out on a limb to pick a golden apple.
  • In June, the Fed cut the federal funds rate by one-quarter of a percentage point, when much of Wall Street had expected a half-point cut. It was as if the Fed had taken a halfhearted attempt to saw off the limb.
  • In July, Fed chairman Alan Greenspan told Congress that he didn’t expect to have to fight deflation by using the guerrilla tactic of buying long-term Treasury notes. Picture Greenspan taking a Bunyanesque chop at the limb with a mighty ax. Down tumbled the bond traders.

“It’s pretty clear that Greenspan is not that popular on Wall Street right now because of what they perceive as conflicting messages that were sent out over the last three months,” says Bob Walters, senior vice president for Quicken Loans.

The last thing the Fed wants to do, Walters says, “is make people scurry in one direction.” But that’s what happened in May, when bond investors overreacted to the Fed’s disinflation worries by driving the 10-year Treasury yield below 3.1 percent. Then bond investors overreacted in the other direction in June and July, after Greenspan’s limb-cutting. They dumped fistfuls of Treasury notes on the market and drove long-term rates upward, including fixed mortgage rates.

“When all the people rush to one side of the boat, what does it do?” Walters says. “It tips over.”

And the hopes of many homeowners sank to a watery grave. Rates on 30-year, fixed-rate mortgages rose by more than a percentage point in a little over a month, strangling the refinancing craze.

That can’t be what Greenspan and the Fed wanted. Members of the rate-setting committee have spent the last year praising the recuperative powers of low mortgage rates. Thus today’s restrained Fed meeting, in which Greenspan tried to keep the boat from listing to either side.

“I don’t think he wants the market to jump around,” Walters says. “He definitely doesn’t want long-term rates to rise. That would defeat what he’s trying to accomplish” — spurring growth in the economy.

The federal funds rate is what Fed-member banks charge one another for overnight loans. It also is known as the overnight rate. The Federal Reserve sets a target for the overnight rate and controls it indirectly by adding and subtracting cash from the banking system.

The prime rate, which is what banks charge to their biggest customers, is 3 percentage points higher than the overnight rate.

Long-term mortgage rates don’t necessarily follow changes in the federal funds rate. Instead, mortgage rates tend to move in the same direction as yields on Treasury notes, which in turn move up and down according to investors’ economic outlook.

The committee’s next meeting is scheduled for Sept. 16.