The Federal Reserve elected not to raise the key interest rate from its historic lows, giving the economy more time to regain strength. A rate hike is unlikely to occur any time soon, as risk of inflation is still dwarfed by the economic challenges that remain to be solved. See the article below from The Street, to learn more.
The Federal Reserve on Wednesday said it would keep its key interest rate target at near zero, signaling that one of the first tools it used to battle the financial crisis is likely to be the last it returns to its toolkit.
The central bank’s Federal Open Markets Committee unanimously maintained its target rate at a range between zero and 0.25%, where it has stood since December. The futures market, stock market, credit market and economy are all betting that interest rates will stay low for the foreseeable future. In any statements about plans to mend the economic crisis, federal officials — including Fed Chairman Ben Bernanke — have explicitly said the same.
The question for today was not whether the Fed would hike rates, but when. The Fed’s terminology on Wednesday again indicated a lengthy duration for its loose monetary policy, using phrases like, “a time,” “some time” and “an extended period.”
“[Hiking rates is] a very big impact with a blunt instrument; it’s not a scalpel, it’s a hatchet,” says Dennis Nason, a former senior banker at Credit Suisse (CS Quote), Citigroup (C Quote) and Wells Fargo (WFC Quote). “They don’t want to be accused of being another [former Fed Chairman Alan] Greenspan, keeping interest rates too low for too long, with too much liquidity and people spending foolishly because of that liquidity.”
There are indications that all the money pumping through the system has been sufficiently effective. The stock market has soared from the lows of March, and is up more than 10% year-to-date as the credit markets have begun to unfreeze. Traders are even getting back in the saddle with complex investment vehicles that were deemed untouchably toxic not that long ago.
As a result, the Fed has begun to unwind liquidity programs directed at the credit markets with narrower goals, like the Commercial Paper Funding Facility. On Wednesday, the Fed added some more color to its plans for these programs, saying that until economic slack has lessened, the central bank would “employ a wide range of tools to promote economic recovery and to preserve price stability.”
Its plan to purchase $1.25 trillion of mortgage-backed securities from Fannie Mae (FNM Quote) and Freddie Mac (FRE Quote) and up to $200 billion worth of agency debt, will end in the first quarter. The Fed’s plans to buy $300 billion of Treasury securities will be complete next month.
Doug Roberts, chief investment strategist for ChannelCapitalResearch.com, believes the Fed may also engineer reverse purchase agreements to drain money from the system before it begins to hike rates.
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“The Fed is going to wait a long, long time before they do that,” says Roberts, who believes the soonest the Fed will raise rates is next year, but likely beyond that. “They’ve got tons of other programs they have to unwind first, which are more flexible — they can kind of stop, start. But when they start raising rates, it will have a big impact.”
Interest-rate policy has wide-ranging effects on not just the markets, but consumers as well. It affects consumer debt like credit-card rates and mortgage rates, as well as commercial and interbank lending that bleeds down to the Average Joe.
The Fed’s main priority is for the economy to stabilize, and must balance two concerns when considering rate changes: Employment and inflation. The jobs market is still atrocious and the only folks expressing concerns about prices in a struggling economy are inflation hawks whose wings were unclipped with surging oil prices last year.
Roberts also notes that policy tends to be progressive, comparing rate movements to troop formations and military strategy. Sudden stops and starts or reversals imply that the Fed doesn’t have a handle on the situation.
“You start having 10% unemployment rising more slowly or topping out, and you start raising rates, that’s not the recipe for reappointment,” says Roberts, author of Follow the Fed to Investment Success.
Although President Obama has already chosen Bernanke for a second term, political pressures haven’t abated. Consumers are still hunkered down, with confidence relatively low. Job losses are only showing possible signs of abating — not reversing. The housing market has only started to gasp for air, largely because of low interest rates and government incentives.
Furthermore, any improvements are coming from a major downturn, and don’t necessarily imply a return to normalcy, or the start of a booming recovery.
“The definition of inflation is too many dollars chasing too few goods, and we don’t have that right now,” says Tim Speiss, head of private client services at the accounting and advisory firm Eisenr LLP. “There’s plenty of slack in the economy; the unemployment rate is supposed to go up…We have extreme consumer conservatism.”
As a result, the Fed may not begin raising rates, at least significantly, for quite some time. Fariborz Ghadar, director of the Center for Global Business Studies at Penn State, expects it to take about three to six months for the government to begin mopping up excess liquidity from the system.
“And I’m optimistic; I think the economy has turned around,” says Ghadar. “But as long as the economy is as slow as it is — even though we’re starting to see an uptick — the Fed is going to be really reluctant to raise the rates.”
He notes that while policy makers believe the economy grew 2.5% to 3% in August, up from 1% in July, the increases are coming from the economic doldrums. He believes the Fed will avoid curtailing growth until it has been sustained.
Jerry Webman, chief economist for OppenheimerFunds, believes the Fed will be closely watching the M2 money-supply metric, which tells how much cash is in circulation, before making an interest-rate move. He notes that while the overall money supply has expanded from the flood of federal cash, banks aren’t really using those funds to lend.
“The banks’ money is under the mattress at the Fed right now,” he says.
Webman says investors are watching several things — including the Fed’s balance sheet, the wind-down of its liquidity programs and the interest rate it pays banks for their reserves — perhaps more than the target rate itself. The Fed’s expanded authorities have lessened the focus on the prime rate, which had been “the biggest decision for the past 25 years,” he says.
Webman expects the rate to begin moving up within the next year, but says it’s too hard to pin down a precise time yet.
“I hope it’s sooner,” says Webman, “because I hope the economy starts improving sooner.”
This article has been republished from The Street. You can also view this article at The Street, an investment news and analysis site.