Fed Opts to Hold Interest Rates Steady
The Federal Reserve called at least a temporary halt Tuesday to its 2-year-old campaign to raise short-term interest rates, suggesting that a slowing economy and previous rate hikes might cool inflation.
The Fed’s policymaking Federal Open Market Committee acknowledged its central predicament: How to steer the economy between the perils of inflation and sluggish economic growth. Inflation has been rising, it said in a statement explaining its action, even as “economic growth has moderated from its quite strong pace earlier this year.”
The central bank left the door open for further rate hikes but also said “inflation pressures seem likely to moderate over time” thanks in part to the slowing economy and previous rate boosts.
Analysts were expecting the rate pause but were divided on whether the Fed would resume raising rates at its next meeting Sept. 20.
“I think we’ve seen the last of the rate increases,” said Jan Hatzius, chief U.S. economist for Goldman Sachs.
Ethan Harris, chief economist for Lehman Bros., said another increase was likely in September. “This may not be a very long pause,” he said.
Ian Shepherdson, chief U.S. economist for High Frequency Economics, said Fed Chairman Ben S. Bernanke appeared ready to tolerate further inflation in the expectation that previous rate increases would ultimately prevail.
“We are even more convinced,” Shepherdson said, “that the Fed is done for this cycle and that the next action will be an ease.”
The decision, unlike most by the Open Market Committee, was not unanimous. Eight committee members joined with Bernanke in support, but Jeffrey M. Lacker, president of the Federal Reserve Bank of Richmond, Va., dissented, preferring another quarter-point rise. It was the first dissent in the four meetings since Bernanke took over from Alan Greenspan in February.
The Fed began raising its benchmark short-term interest rate by 0.25 percentage point in June 2004, when the rate was 1%. Seventeen committee meetings later, in June of this year, the rate stood at 5.25%.
Economic growth has predictably slowed during those two years, from 3.9% in 2004 to 2.5% in the 12 months that ended in June, in part because of a cooling housing market.
But to the Fed’s consternation, most measures of inflation are higher now than they had been when the rate increases began. The consumer price index rose 3.4% in the 12 months that ended in June 2004. In the most recent 12 months, it is up 4.3%.
The Fed’s decision came hours after the Labor Department issued a double dose of bad economic news that highlighted the Fed’s predicament as it tries to avoid a repeat of the “stagflation” -- stagnant growth with high inflation -- of the 1970s. The Labor Department reported a combination of rising labor costs and small productivity gains.
Unit labor costs -- the price of labor to produce a given amount of goods or services -- rose at a 4.2% annual rate in the second quarter, the Labor Department said. That was the highest since the first quarter of 2001, before the most recent recession. Nigel Gault, U.S. economist for Global Insight, said it was “inconsistent with keeping price inflation in a 1% to 2% range that the Fed would prefer.”
The Labor Department also reported that nonfarm worker productivity advanced by an annual rate of only 1.1%, down sharply from the 4.3% increase registered in the first quarter.
The surge in labor costs, while good news for workers, supports a continuation of the Fed’s policy of raising interest rates. But weak productivity would only be aggravated by higher rates, which would make it more expensive for businesses to raise capital.
Although the Fed reached a different conclusion this time, the language accompanying Tuesday’s decision was remarkably similar to its statement on the most recent rate hike June 29.
One passage from June that was not repeated Tuesday stated that “ongoing productivity gains have held down the rise in unit labor costs.” These were the very subjects covered by Tuesday’s discouraging reports from the Labor Department.
Instead, the Fed said Tuesday that policies already in place should tamp down inflation without another rate increase. That reflects the Fed’s concern that it could raise rates so high that it would extinguish economic growth in the process of controlling inflation.
Analysts said it takes 12 months before interest-rate increases have their full anti-inflationary effect. That would mean the last eight interest-rate increases -- a total of 2 percentage points -- are still at least partially in the pipeline.
Making the Fed’s job tougher still, high interest rates typically cause economic growth to decline before they bring inflation down, said John Miller, head of municipal bond trading for Nuveen Investments in Chicago. So policymakers have to rely on their forecasts to decide when to act and when to stop, a particularly uncomfortable challenge when growth is waning and inflation is not.
“The trick is to be forward-looking,” Miller said. “If you’re responding to indicators of past inflation, that’s a recipe for overshooting.”
Like many other analysts, Miller said he was surprised at the dovish tone of the Fed’s announcement. “It becomes more likely that we have seen the last rate increase,” he said.
Hatzius likewise said he did not expect such a dovish tone. “I’m surprised the Fed has put so many chips on this,” he said.
Robert Van Battenburg, head of global research for Louis Capital Markets, said he took the Fed at its word when it said subsequent interest-rate decisions would depend on future economic data. “It’s all up in the air whether they hike rates again or not,” he said.
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Federal Reserve’s Statement
Here is the statement about interest rates the Federal Reserve issued Tuesday:
The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5.25%.
Economic growth has moderated from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.
Readings on core inflation have been elevated in recent months, and the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures. However, inflation pressures seem likely to moderate over time, reflecting contained inflation expectations and the cumulative effects of monetary policy actions and other factors restraining aggregate demand.
Nonetheless, the committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.
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Outlook for other interest rates
Here is where some key interest rates stand and the outlook after the Federal Reserve’s kept its short-term rate at 5.25%.
Item - Prime lending rate
Current rate - 8.25%
Outlook - As the Fed held steady on Tuesday, so did the prime lending rate, at 8.25%. Banks have been raising that rate for two years with each increase in the Fed’s rate. A steady prime rate will give a breather to consumers who have home equity credit lines and other loans tied to the prime.
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Item - Money market fund yield (seven-day average)
Current rate - 4.70%
Outlook - Money fund yields have been climbing for the last two years as the Fed tightened credit, lifting rates on short-term corporate and government IOUs. Because money fund yields lag the Fed’s rate, the funds’ yields may continue to rise for a few more weeks, but then are likely to level out unless the Fed boosts its rate again.
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Item - One-year CD yield (U.S. average)
Current rate - 3.96%
Outlook - The Fed’s rate-raising campaign has been a blessing for many people with money in the bank. The average one-year CD yield has risen from 3.30% at the start of this year. But the Fed’s decision may slow or halt increases in CD yields, except at banks that are hungry for deposits to fund loan demand.
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Item - 10-year Treasury note yield
Current rate - 4.92%.
Outlook - Bond yields take their cue from the economy’s strength and the outlook for inflation. Yields have been falling in recent weeks as some investors bet that the economy would slow and that the Fed would go on hold with short-term rates. The 10-year T-note peaked at 5.24% June 28. Many analysts don’t expect bond yields to fall much more unless the economy downshifts dramatically.
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Item - 30-year mortgage rate (Freddie Mac average)
Current rate - 6.63%
Outlook - Mortgage rates generally follow long-term bond yields. The 30-year mortgage rate peaked at 6.80% in mid-July. Without a significant further decline in bond yields, mortgages aren’t likely to fall sharply.
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Graphics reporting by Tom Petruno
Sources: Informa Research Services, IMoneyNet, Bloomberg News
