Fed Leaves Key Interest Rate at 40-Year Low

Federal Reserve policymakers decided Tuesday to keep the central bank’s signal-sending interest rate at a four-decade low of 1.25% but indicated that they would order new rate cuts if the U.S. economy continued to show signs of weakness.

Fed Chairman Alan Greenspan and his colleagues on the policymaking Federal Open Market Committee warned that the nation may face a new threat in deflation, or a general decline in prices. Although the central bankers have discussed deflation over the last year, they had for the most part discounted its dangers until Tuesday.

Analysts said the Fed’s latest action set the stage for as much as a half-point cut in the federal funds rate, the interest that banks charge one another for short-term loans, if the economy doesn’t show signs of snapping back after the Iraq war.

“It certainly raises the odds they’re going to cut before they raise rates,” said Stephen G. Cecchetti, an economist at Ohio State University in Columbus and a former Fed staffer.

The Fed’s new assessment of the economy represents a drastic change from its March reading, when the central bank concluded that uncertainties surrounding the yet-to-be-launched war were so great it was impossible to gauge economic conditions.

This time, the bank went in the opposite direction, offering substantially more detail than usual and leaving some analysts convinced that policymakers are laying the groundwork for a new approach to managing the economy should it not make a quick comeback.

In their Tuesday statement, Fed officials said that although the end of the war had helped lift consumer confidence and stock prices, recent employment and production statistics “have proven disappointing.”

Although officials said the economy should begin recovering shortly, they suggested that the improvement could stretch over “the next few quarters” -- considerably longer than they have previously suggested.

And, they warned, the resumption of strong growth is no guarantee against deflation -- or what they termed “an unwelcome substantial fall in inflation.”

As a result, the central bankers concluded that “the balance of risks ... is weighted toward weakness over the foreseeable future.”

Some analysts interpreted the Fed’s new talkativeness as a tactical maneuver aimed at answering critics who charge its “balance of risks” statement sows confusion, or at nudging financial markets in the direction the central bank wants them to move.

“Put yourself in the shoes of a member of the Federal Open Market Committee,” wrote Goldman Sachs economists William Dudley and Edward F. McKelvey.

“With short-term [interest] rates already extremely low, and the economy still sluggish ... it’s probably best not to signal an undue degree of worry about growth.”

At the same time, the economists said, policymakers would like to see long-term market interest rates decline further -- something they would do if financial market players were convinced that the Fed would further cut the short-term rates it controls to cope with deflation.

Other analysts took the Fed’s latest statement as a sign that the central bank is increasingly worried about deflation and ready to try a new economic management technique if conditions don’t improve.

“In a sense, what we have is the Fed implicitly targeting inflation” or seeking to set off a mild but generalized price increase, said Paul Kasriel, chief economist with Northern Trust Corp. in Chicago.

If Kasriel is correct and the central bank is considering a new goal, that would represent a substantial about-face for an institution that has spent much of the last two decades trying to crush inflation.

If the Fed’s new warning proves right, that would require a dizzying change of direction for American consumers and investors who grew up on fears of inflation, not deflation.

A price decline for individual items -- computers, for example -- is a good thing because consumers can buy more for less money.

But economists say that a generalized price decline can wreak havoc by, among other things, persuading consumers and businesses to put off purchases of items they know they can get for less later, leaving an economy stuck in the doldrums.

Some analysts suggest that slipping prices may be behind some of the sluggishness of the U.S. economy. After growing at a 4% annual pace between July and September last year, growth slowed to a 1.4% pace in the October-through-December quarter and a 1.6% rate in the most recent January-through-March period.

With its funds rate at its lowest level since 1961, the Fed is running out of tools with which to do much about the economy.

“Fed officials find themselves in a very, very awkward position,” said Cecchetti, the former Fed staffer.