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Fed to leave interest rates unchanged until at least 2014

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The Federal Reserve announced Wednesday it would leave interest rates at rock bottom for at least another three years. But it also made history when it disclosed for the first time policymakers' forecasts of what interest rates may be down the line. 

FED LEAVES LENDING RATES
AT HISTORIC LOWS


The prime rate and the federal funds rate have not changed since December of 2008, when the nation was wrestling with the worst of the economic downturn. The Fed had aggressively cut the fed funds rate in the months prior to that as the economy deteriorated. 
 
The chart above shows how far rates have fallen since July 2007 -- just before the recession began. (NOTE: The prime rate, which most credit issuers use in setting credit card rates, is always 3 percentage points higher than the federal funds rate.)

The Fed's announcement that it would leave the federal funds rate alone until at least late 2014 means that credit card holders won't have to worry about a sudden rate hike any time soon. Most credit cards are variable rate cards, meaning they are tied to the prime rate, which is typically 3 percentage points above the federal funds rate. When the federal funds rate is raised, the annual percentage rates (APRs) of variable rate cards immediately go up as well. Beginning Wednesday, cardholders will also be able to see, for the first time in history, when individual members of the Federal Open Market Committee (FOMC) expect the federal funds rate to go up -- or down. The interest rate forecasts are only opinions, based on real-time data. However, they are part of an unprecedented move by the Fed to increase transparency and make their policy decisions less inscrutable to the public. 

"It's another step in the process of the Fed becoming more transparent that they started in the mid-1990s," says Ann Owen, a professor of economics at Hamilton College. However, "what's different about this is that it's not about what the Fed has done in the past, but what the Fed is going to do in the future."

Why keep rates low?
Members of the Fed's Federal Open Market Committee -- which sets monetary policy (economist-speak for controlling the country's money supply) -- voted Wednesday -- as they have for the past three years -- to keep the federal funds rate at 0 percent to 0.25 percent. The committee pushed the rate down to today's historically low levels in December 2008 after the U.S. plunged into an economic tailspin. Since then, the FOMC has declined to raise the federal funds rate until it sees signs that the economy is significantly improving.

"The Federal Reserve is keeping the federal funds rate low because they believe that the economy is still in the early stages of recovery," says Owen. "I think they're concerned that if they raise the rates they will knock the economy back in to another recession."

Economists say that members of the Federal Reserve also believe that if they keep interest rates low, it will encourage businesses to invest in growth now -- rather than wait for a more certain economy -- and it will spur consumers to spend, particularly on big ticket items such as cars and new homes.

"When they keep their rates low, other interest rates tend to be low," says Robert Mellman, a senior economist at J.P. Morgan Chase. "Mortgage rates have come down below 4 percent. Auto finance rates are lower than they used to be. And for companies, if they're big enough to have access to financial markets or they have long-term access to rates, they can also borrow at relatively low rates."

At the same time, says Mellman, "other things being equal, the lower the federal funds rate, the lower the credit card rate." So if you keep paying your bills on time, your credit card rate won't see a sudden increase until the Federal Reserve decides to raise rates again. (Your credit card issuer can decide to raise your interest rate for other reasons. However, as long as you're not more than 60 days late with your payments, they are required by the Credit CARD Act of 2009 to give you 45 days' notice before they touch your APR.)

I think they're concerned that if they raise the rates they will knock the economy back in to another recession.

-- Ann Owen
Professor of economics at Hamilton College

Looking at 2014 and beyond
When the Fed will decide to raise interest rates again is an open question. In Wednesday's statement, the Fed said that it is unlikely to raise the federal funds rate until at least late 2014. However, economic forces -- such as growing inflation or a surprisingly rapid economic recovery -- could prompt the Fed to raise rates sooner than forecast.   

That's because the Federal Reserve has "a dual mandate," says Stephen Williamson, a professor of economics at Washington University in St. Louis. "Congress says the Fed should be concerned with two things. One is price stability and the other is things going on in the real economy," such as unemployment. 

As long as inflation is relatively stable, the Federal Reserve will concentrate on policies designed to help trigger economic growth. However, if prices for goods and services in the U.S. get too high, the Fed will "tighten monetary policy by increasing rates," says Williamson.

That said, there's wide agreement that interest rates probably won't move for at least another year. According to the forecasts released Wednesday afternoon, 11 out of 17 Fed policymakers think the federal funds rate will probably stay the same throughout 2013. However, only six think the rate will remain at rock bottom in 2014. The remaining 11 policymakers vary widely in their views, with at least five policymakers predicting that the fed funds rate will reach 2 percent or higher in two years. This difference in opinion underscores the uncertainty that policymakers face when predicting the economy's fate.   

Policymakers' longer run forecasts are significantly more optimistic. Sixteen out of 17 policymakers expect interest rates to rise to at least 4 percent or higher over the next five or six years, with the lone dissenter projecting that rates will be just under 4 percent. That means, if policymakers are right and the economy recovers as expected, credit cardholders could see their APRs rise by up to four percentage points in five or six years.   

A small but historic step toward transparency
While no one knows what the Fed's rate decisions will be in 2014, analysts now have one more tool in their arsenal that will make it easier to predict with more certainty whether the Fed will raise or lower interest rates in the future.  

For the first time in its history, after every two-day FOMC meeting, the Federal Reserve will release policymakers' projections of what they believe will be the appropriate federal funds rate for the next several years -- and when they think the Federal Reserve will finally raise the federal funds rate.

The goal, say experts, is to make it easier for Federal Reserve watchers -- such as analysts, politicians and investors -- to understand the thinking behind Fed policymakers' decisions. By releasing forecasts from each of the 12 active members and the five alternate members of the FOMC, the Fed is providing more insight into the debates about interest rates that go on behind closed doors.  

"A primary motivation for releasing this information is really to help people understand what the Federal Reserve decision-making process is," says Owen. "There's been a lot of criticism of the Fed that indicates that some people don't understand what the Fed is dealing with, what they're thinking and how they make their decisions."

By opening the doors a bit wider, the Fed hopes that the public will better understand why it implemented certain policies. "The Federal Reserve thinks that it's easier for them to do their job if the investing public and the public more generally understand their thinking," says Mellman. "If you go back a year, they were fairly convinced that inflation would be reasonably low and unemployment would stay high ... And at that time, there were a fair number of people and politicians thinking the Fed was crazy for keeping rates this low and that inflation would go sky high."  

The Fed also hopes that the projections will give more certainty to investors, said Federal Reserve chairman Ben Bernanke in a press conference on Wednesday. "By issuing these expected policy rate information, we hope to convey to the market the extent to which there is support on the committee for maintaining rates at a low level for a significant time." However, Bernanke later noted, "We're not absolutists."

If economic conditions warrant a different course, the FOMC will debate it at the FOMC meeting and eventually come to an agreement. "We don't set the federal funds rate by having members send in their vote and not have a meeting. We have a meeting for a reason, which is to talk to each other and try to come to some kind of consensus. So the FOMC will always, in some sense, trump the projections of forward interest rates." However, he also noted, "the projections should give significant information about where the FOMC is likely to go."  

The "notoriously opaque" Fed
The release of the federal funds forecast is also part of an unprecendented series of steps that the Fed has taken to be more transparent. "The Fed has been at work for quite a while trying to communicate the rationale for its actions more clearly to the public at large," says V.V. Chari, a professor of economics at the University of Minnesota in Minneapolis.

I don't have a lot of confidence in their transparency.

-- Robert Auerbach
Professor of public affairs, University of Texas

In 2011, for example, Federal Reserve chairman Ben Bernanke -- a longtime advocate of greater transparency -- began holding regularly scheduled press conferences for the first time in the Federal Reserve's history. 

However, the notoriously opaque Fed began opening itself up incrementally much earlier than that. Experts say that the Fed first began releasing select information to the general public in the mid-1970s. But it wasn't until the mid-1990s that the Federal Reserve began disclosing information about interest rates.  

Before then, the Federal Reserve's monetary policy decisions were so closely guarded that "they didn't even make public statements ... about what the federal funds rate target was," says Williamson. "People had to make a lot of guesses about what was going on."  

The Fed was so cryptic, in fact, that reporters used to make guesses about what the Fed might do by analyzing then Federal Reserve chairman Alan Greenspan's briefcase as he went into the closed-door FOMC meetings, according to a fall 2000 article by the Federal Reserve Bank of St. Louis. If the briefcase looked fat, reporters speculated, then it might mean the briefcase "is full of evidence that has been gathered by Greenspan to persuade other members of the FOMC to vote for a higher interest rate target."

Is more change needed?
Not all analysts, however, are convinced that the Federal Reserve's latest steps toward transparency are enough. "I don't have a lot of confidence in their transparency," says Robert Auerbach, a professor of public affairs at the University of Texas at Austin and author of "Deception and Abuse at the Fed." "Bernanke has press conferences, but he doesn't reveal a lot in the press conferences."

Auerbach says the Fed's latest step in releasing policymaker's forecasts could be "beneficial," but it may also be problematic if people misinterpret the forecasts as gospel. "I teach statistics ... and there's no way for anyone to predict the future," says Auerbach. However, if Federal Reserve policymakers are clear that the forecasts are "just a guesstimate, that would be much more satisfactory."

Published: January 25, 2012



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