Fed Keeps Low Rate, Hints at Shift Coming

The Federal Reserve left its signal-sending interest rate at a 45-year-low 1% on Tuesday, but suggested that its three-year rate-cutting campaign was over and that it could raise rates next year.

The central bank’s warning, which many analysts said was inevitable given the economy’s strong recent performance, sent bond and stock prices mostly lower.

Bank of America economist Peter Kretzmer said Fed policymakers had given “a nod toward an eventual interest-rate tightening.” They “didn’t want to do too much too fast,” he said, “but this is a marker.”

If there is evidence that the economy is continuing to boom, threatening to cause inflation, “they will move sooner than expected.”

Kretzmer predicted that the central bank would raise its federal funds rate by mid-2004. Policymakers Tuesday finessed controversy over whether they would eliminate a pledge to keep rates low for “a considerable period” -- a phrase that has become a stock part of central bank policy statements since last summer.

They left the phrase in their latest statement, but changed key words around it.

When they met in late October, policymakers said that their worry about an “unwelcome fall in inflation exceeds that of a rise in inflation,” so interest rates should be held down for “a considerable period.”

Low rates can help fight a fall in inflation, or deflation, by spurring growth and causing prices to rise.

On Tuesday, by contrast, policymakers said that “the probability of an unwelcome fall in inflation has diminished ... and now appears almost equal to that of a rise in inflation.”

Nevertheless, they said that rates should be held down for “a considerable period” because inflation is “quite low and resource use slack.”

Gregory D. Hess, an economist with Claremont McKenna College in Claremont, said policymakers were “trying to set some upper limit to how long a ‘considerable period’ is.”

Now, instead of suggesting that the era of low rates could continue indefinitely, the central bank has declared that it would end when prices pick up and the economy’s excess capacity is put to use, Hess said.

Some change in the Fed’s position was all but inevitable after the government reported two weeks ago that the U.S. economy roared forward at an 8.2% annual rate in July-through-September quarter and signs indicated that the economy is continuing to outperform most forecasts.

But the central bank has been reluctant to reverse course and begin raising interest rates because of concerns about stifling the nascent comeback and because a key indicator of economic recovery -- jobs growth -- has yet to show substantial improvement.

U.S. employers added about 57,000 workers in November.

That figure is only about a third of the 150,000 that many analysts had predicted and well short of the economy’s job-creation performance in past recoveries.

In their statement Tuesday, policymakers took note of the recent strengthening of the economy, writing that “output is expanding briskly and the labor market appears to be improving modestly.” But they suggested that in the absence of inflation, there was no need to raise rates immediately.

In fact, while the federal funds rate -- the Fed-set interest that banks charge each other for short-term loans -- has hovered at its lowest level in decades for the last two years, market-set interest rates have climbed in recent months, suggesting that the demand for loans, and their cost, is picking up along with the economy.

Analysts said that if growth continued at even at half the pace of last quarter, prices eventually would begin climbing, forcing the Fed to start tapping the economic brakes by raising the funds rate.

“If the economy keeps going, a 1% funds rate can’t last forever,” said Neal Soss, chief economist with Credit Suisse First Boston in New York. Forecasts of when the central bank could start raising rates range from next month to 2005. But virtually all economists agree the Fed’s campaign of rate cuts is at an end.