Fed Leaves Rate at 45-Year Low

The central bank says it will maintain this policy stance for a considerable period.

 By Tom Petruno

        Times Staff Writer

       August 13, 2003

        

The Federal Reserve sent a stronger message Tuesday that it wouldn't be raising short-term interest rates anytime soon, hoping to give the economy a chance to build up a substantial head of steam.

        That was more bad news for Americans who rely on income from bank accounts and money market funds, though it could help owners of stocks and bonds.

       At their mid-summer meeting. Fed policymakers left their key short-term rate at a 45-year low of 1%, as expected, and repeated much of what they said in late June: They see the odds as evenly balanced between business activity picking up and slowing down, but remain worried about inflation getting too low for the economy's good.

        Given that environment, the Fed indicated in its post-meeting statement that it would maintain its policy of rock-bottom short-term rates "for a considerable period."

        The word "considerable" was new to the Fed's official lexicon and was viewed by Wall Street as an attempt by Chairman Alan Greenspan and his peers to calm owners of long-term bonds.

        Yields on bonds have soared since mid-June, partly on fears that the Fed was getting closer to tightening credit, which could drive all interest rates higher.

       Exactly what the Fed meant by a "considerable" amount of time was left to interpretation.

        "Six to nine months wouldn't be unreasonable to assume" for the Fed to be on hold, said Anthony Karydakis, senior financial economist at Bane One Capital Markets in Chicago.

       Others said it could mean as long as one year.

        Some recent economic data have been encouraging, and the Fed acknowledged that in its statement, saying that "spending is firming" and that productivity gains were "robust."

       But the central bank returned to a concern it first began to emphasize early in May: the potential for deflation — a widespread drop in prices — to take hold in the economy.

       The Fed is troubled by that possibility because deflation can become a downward spiral, as consumers and businesses postpone spending, figuring goods and services can only get cheaper. Deflation has racked

       Japan's economy in recent years.

       The Fed's statement concluded with an apparent reference to deflation: "The committee judges that, on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future."

        Asha Bangalore, economist at Northern Trust Co. in Chicago, said Greenspan and other Fed officials have adopted the inflation outlook of fellow Fed Gov. Ben Bemanke. His thesis, Bangalore said, is that even if the economy grows at a brisk rate for the next year, there is so much unused business capacity remaining from the 1990s boom that companies will remain hard-pressed to raise prices.

        Some analysts lauded the Fed for keeping its overall message relatively simple Tuesday.

        "It was a lucid, less complicated statement than the last one," Karydakis said.

        The stock market responded with a rally. The Dow Jones industrial average jumped after the Fed made its announcement at 11:15 PDT. It ended up 92.71 points, or 1%, at 9,310.06.

        In the Treasury bond market, yields on shorter-term securities eased, a sign investors may be more trusting that the Fed won't tighten credit soon. The two-year T-note yield dipped to 1.72% from 1.76% on Monday.

        But longer-term bond yields rose. The 10-year T-note yield, for example, ended at 4.43%, up from 4.35% on

        Monday and near the one-year closing high of 4.44% reached July 29.

        If bond yields stay up, mortgage rates also are likely to remain elevated, further slowing the housing market.

        Despite Tuesday's jump in bond yields, Karydakis said the Fed's pledge to hold the line on short-term rates

        "gradually will resonate with the bond market." That could push the 10-year T-note down to between 4% and 4.25% in coming months, he said.

        Others weren't as confident. "In three or four months, if the economy is ripping along, 'considerable' is going to be [perceived as] a lot shorter time" in terms of how long the Fed can wait to tighten credit, said Gregg

        Cohen, a bond trader at CIBC World Markets in New York.

        For that reason, bond investors may not be willing to accept substantially lower yields despite the Fed's stronger pledge, he said.

        The bond market also still is smarting from what some traders say was an about-face by the Fed. The central bank suggested in May that it could resort to extraordinary moves to push long-term interest rates down, including the direct purchase of bonds in the marketplace.

        Fed officials in July seemed to backtrack from that idea, which helped trigger a sell-off in bonds.

        If the Fed is trying to placate bond owners, it's partly at the expense of Americans who have a total of $5 trillion in short-term bank savings accounts and money market mutual funds.

        Those savers are virtually assured that their money will continue to earn dismally low yields.

        James Glassman, economist at J.P. Morgan Securities in New York, said his mother "keeps asking me,

        'When is that guy going to start raising rates?'" referring to Greenspan.

Conservative savers effectively are subsidizing other parts of the economy, and stock and bond markets, as long as the Fed keeps short-term rates so low, Glassman said.

        For borrowers, meanwhile, the Fed's stance means the bank prime lending rate, a benchmark for business and consume/loans, is likely to hold at 4% at least into the first quarter of 2004. Banks peg the prime to the

        Fed's key rate, the federal funds rate, which is what banks charge one another for overnight loans.