As expected, Fed keeps rates at rock bottom

By Kelly Dilworth

If you have good credit and are ready to buy a new fridge or refinance your mortgage, now is a good time to do it. The Federal Reserve announced Wednesday that it will continue to leave today's record low rates near zero.

"Information received since the Federal Open Market Committee (FOMC) met in June suggests that economic activity decelerated somewhat over the first half of this year," said the Fed in a post-meeting statement. "Growth in employment has been slow in recent months, and the unemployment rate remains elevated. Business fixed investment has continued to advance. Household spending has been rising at a somewhat slower pace than earlier in the year. Despite some further signs of improvement, the housing sector remains depressed." In addition, the Fed said, "strains in global financial markets continue to pose significant downside risks to the economic outlook."

In light of the weak data, the members of the committee voted to keep the federal funds rate target at 0 to 0.25 percent.

The Fed's reluctance to raise the federal funds rate target is especially good news for high-interest borrowers, such as credit card holders, because it means they won't have to worry about a sudden rate hike any time soon. The federal funds rate is the rate at which banks trade balances held at the Federal Reserve. The Fed meets eight times a year to set a target rate for such trading, which it imposes by adding to or subtracting from the money supply.

Why that activity matters to cardholders is that most credit cards are variable rate cards tied to the prime rate, which is typically 3 percentage points above the federal funds target rate. When the federal funds rate is raised, the annual percentage rates (APRs) of variable rate cards tend to immediately go up as well.  

The Fed hopes that by keeping the federal funds rate at rock bottom, it will encourage consumers and businesses to borrow and invest more, despite the uncertain economic recovery.

"They're trying to encourage borrowing by consumers and businesses," says Don Dutkowsky, a professor of economics in the Maxwell School of Citizenship and Public Affairs at Syracuse University. By setting the federal funds rate near zero, the Fed helps push down other interest rates and make borrowing more attractive.

The Fed has also announced its intention to keep the federal funds rate target near zero until at least late 2014. That should ensure that lenders that tie their loans to the prime rate will continue to keep the rates they charge borrowers relatively low for the foreseeable future, say experts. "Longer-term interest rates are determined not only by what the rate is today, but also by what people think will happen in the future," says James Butkiewicz, a professor of economics at the University of Delaware. "If [lenders] think the rate is low today, but will go up next year, then rates on mortgages [or] car loans will be higher cause they're thinking about the life of the loan."

Cheap loans failing to prod spending
In theory, the lower interest rates set by the Fed should trickle down to consumers and small-business owners and encourage them to take advantage of cheaper loans on credit cards, homes and automobiles. It should also give consumers a fresh incentive to refinance their existing loans and spend those savings elsewhere, explains Jim Johannes, director of the Puelicher Center for Banking Education at the University of Wisconsin. "The only way the Fed can do this is to try to lower rates even more," he says.

The problem is that rates are already as low as they can go and consumers still aren't spending. "The economy is going nowhere for the most part because consumers aren't borrowing," says Johannes. That's making it harder for businesses to expand and hire new workers because they can't depend on a steady stream of customers.

Private-sector employers added just 163,000 jobs from June to July, according to the National Employment Report released Wednesday by payroll provider ADP. That's significantly more than was forecast, say ADP analysts, but still well below what's needed to push the economy forward at a faster rate.  

Consumer spending, in turn, remained flat in June after declining the previous month, according to figures released Tuesday by the Commerce Department. The agency also reported that some groups' incomes rose significantly at the beginning of the summer. However, retailers didn't see a significant bump in sales as a result. Retail sales fell for the third straight month in June, according to the National Retail Federation, worrying retailers gearing up for back-to-school sales.

A problem for the Fed
The latest string of disappointing economic data underscores the significant challenges facing the Federal Reserve as it weighs what to do next. "The Federal Reserve, in some ways, has its back to the wall," says Syracuse University's Dutkowsky. "The federal funds rate is very close to zero. They can't put that target down anymore."

The Fed also can't force consumers to spend as much as it would like to get the economy growing at a faster pace. "It takes more than low interest rates for consumers and businesses to make the decision to buy those big-ticket items," he says.

That's especially true when the country's economic future is so uncertain. "In a slow economy, people and businesses are reluctant to make those big-ticket purchases that these low interest rates are trying to attract," adds Dutkowsky, because they are thinking about their own self-interest.

Taking out a loan involves a great deal of risk and uncertainty, he explains. For example, you might lose your job, but you're still on the hook for the credit card balance you racked up when you thought you had a steady income. "If you're not confident about the future state of your household or business, this is not the time to extend yourself into the type of spending that would entail this type of borrowing."

Banks also make it harder for consumers to spend a significant amount because they are keeping a tight rein on the amount they lend. "Anecdotal evidence seems to indicate that banks have a lot of money to lend, but they only want to lend to triple-A consumers and businesses," says the University of Delaware's Butkiewicz. "That's really holding things back."

Banks are also contending with significantly more regulation, says Butkiewicz, which slows them down and makes them less willing to take bigger risks. "The comparison I do for my students is, I always ask them, 'How do people drive after they're received a speeding ticket?'" says Butkiewicz. "The answer is they drive a little cautiously." Bankers got a big speeding ticket in the form of tighter regulations after the financial crisis of 2008 and are likely to remain cautious going forward.

"It's a little bit of a Catch-22," he adds. Banks will likely open their doors wider to new borrowers once the economy significantly improves. However, "until things improve, they aren't going to open the doors much," he says.

That said, not all economists think that lending to consumers with lower credit scores will do the trick. "Some people have mentioned that the Fed should incent banks to lend more, but making loans that won't get repaid won't really help anything," says the University of Wisconsin's Johannes. "So they are in a real pickle and as the textbooks say 'are pushing on a string.' They are in a difficult situation caused by so many structural imbalances in the economy."  

No new stimulus -- for now    
The Fed also voted Wednesday to keep monetary policy as is and not inject more stimulus into the economy in the form of additional quantitative easing and other types of Fed programs. However, Bernanke has made clear that additional measures are still on the table.

Several economists have called for the Fed to do more to help prop up the flagging economy. However, many others argue that there's not much more the Fed can do. "Ben Bernanke is an excellent economist," says Syracuse's Dutkowsky. "He's kind of aware that monetary policy may be able to do a little more, but not a whole lot."

That's especially true, he says, since the Fed is dealing with the aftermath of a financial services recession that historically takes longer to recover from and doesn't respond to this type of policy as effectively. "The Fed is just about out of bullets for this type of economy," says Dutkowsky. "Interest rates are already at record lows and Fed policy and monetary policy relies on borrowing and lending and that is not working right now."

"With this type of headache in the economy, the aspirin of monetary policy is not an overly effective remedy," he adds.

See related: Fed to leave interest rates unchanged until at least 2014

Published: August 1, 2012

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