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Fed again holds rates steady, but change may come soon

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June 2009 Federal Reserve policy announcement

Although, as expected, the Federal Reserve didn't boost interest rates with its latest monetary policy announcement, analysts say it is only a matter of time before the Fed hikes its key lending rate.

At the conclusion of a two-day meeting, the Fed voted unanimously to leave its federal funds rate at a range of 0 percent to 0.25 percent, keeping the prime rate at 3.25. Variable rate credit cards -- which account for the majority of plastic -- have annual percentage rates that are pegged to the prime rate.

"In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability," the Fed said in a statement. "The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period." In other words, don't expect an impending rate hike just yet.

Change will come, eventually
Although changes to the Fed's key lending rate typically influence APRs for variable rate cards, cardholders may already be paying more to borrow on plastic, as banks seek to lock in rate increases before new credit card laws restrict their ability to do so.

Meanwhile, the challenge for Fed policymakers is to stimulate the economy without causing it to overheat, which could spur inflation. Amid signs the economy is on the path to eventual recovery, analysts predict current monetary policy will eventually change. "I think the Fed is getting near the point where they are willing to discuss in public an exit strategy," says Gregory Miller, chief economist with SunTrust Bank in Atlanta. However, that exit strategy may not include immediately hiking interest rates. 

Instead, the initial shifts in Fed policy may include changes to the several nontraditional forms of monetary policy the central bank currently has under way, including the purchase of Treasurys and interest paid on reserve funds lenders maintain with the central bank. "This is a process, not a permanent situation where this stimulus will always be there," says Huntington National Bank Senior Economist George Mokrzan, explaining that these programs instead represent jump starts and supplemental supports for the troubled economy.

Analysts say that when the economic recovery does get under way, those policies may see a change before the fed funds rate does. "Maybe those programs will be phased out as it is clear the markets return to normal," Mokrzan says, adding that the programs can always be brought back as needed. According to Miller, "The Fed has instituted a kitchen sink's worth of policy in addition to the traditional manipulation of the federal funds rate." The introduction of alternate monetary policy makes the current economic situation unique. "This time, the Fed could be well into the process of tightening financial conditions before they start operating with the federal funds rate," Miller says.

I think the Fed is getting near the point where they are willing to discuss in public an exit strategy.

-- Gregory Miller    
Chief economist, SunTrust Bank    

That "winding down" process could incorporate several steps. According to Dana Johnson, chief economist with Comerica Bank in Dallas, the Fed could initially phase out its special liquidity facilities before ending its purchase of securities and finally boosting the fed funds rate.

For example, that unwinding process may also include a push from the Fed to get banks lending money. Banks are required to maintain some reserve funds with the Fed. Analysts say that within the last year, the Fed has started paying interest on those funds maintained above the required thresholds. By reducing the interest the Fed currently pays, it could encourage credit card issuers to take on more risk by seeking out better returns through lending to consumers, analysts explain.

While the Fed currently represents an attractive place for banks to stash cash -- since lenders' money is so safe there -- an economic recovery may also prompt a change. "Banks don't want to lose money on people becoming unemployed, for example, and being unable to pay their balances," says Huntington Bancorp's Mokrzan. "As the economy starts to improve and that risk goes down, that would increase their willingness to loan credit via credit cards and other ways."

However the Fed addresses the gradual reversal of existing monetary policy, the task won't be an easy one. Mokrzan compares the Fed to a race car driver who must "wind through turns, and make the turns properly, so enough stimulus can be taken out without going into the wall, in terms of knocking the economy out."

Other experts stress that on the road to recovery, raising interest rates will mark the central bank's final lap. The fed funds rate's high-profile status makes it the most powerful tool in the Fed's arsenal. 

"That's their high caliber instrument. The others are more surgical," Miller says. 

See related: Obama signs credit card reforms into law, Credit card interest rates unchanged ahead of Fed meeting

Published: June 24, 2009


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