Archive for Wednesday, May 7, 2003

Fed leaves rates unchanged

Central bank signals possible cuts, fears deflation in prices

May 7, 2003

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— The Federal Reserve left interest rates unchanged on Tuesday but signaled that cuts could be coming, given worries about the economy's uncertain recovery and the possibility of a destabilizing fall in prices.

Many analysts said an unusually detailed statement by Federal Reserve Chairman Alan Greenspan and his colleagues convinced them the central bank would cut rates at its next meeting on June 24-25 if the economy hadn't started to post stronger growth.

"By June, I think there will be hints of an economic rebound, but it will be a highly uncertain thing, and the Fed does not want to take any chances here," said economist David Jones, the author of four books on the Greenspan Fed.

The Fed has not reduced its target for the federal funds rate, the interest that banks charge one another, since Nov. 6 when it slashed it by a half-point to a 41-year low of 1.25 percent, the 12th reduction in an aggressive easing campaign that began in January 2001.

Those low rates have driven mortgage rates to their lowest levels since the early 1960s, triggering record sales of new and existing homes and a surge in mortgage refinancing.

However, outside of housing, the economy has been moving sideways during the past six months as consumer confidence plunged during the runup to the Iraq war and businesses, with excess capacity, remained reluctant to invest in new plants and equipment.

The nation's unemployment rate returned to an eight-year high of 6 percent in April with more than a half-million jobs lost during the past three months.

Deflation a primary concern

In its statement explaining the decision to leave rates unchanged, the Fed mentioned recent disappointing statistics on employment and factory production although it said that data "was mostly reflecting decisions made before the conclusion of hostilities."

With the end of the Iraq war, oil prices have fallen and consumer confidence and financial markets have rebounded, the Fed said, observing that this should "foster an improving economic climate over time."

However, the central bank's statement noted a new, although it said remote, concern that the United States, which has been struggling for three years to overcome the bursting of the U.S. stock market bubble, could go the way of Japan and encounter a bout of falling prices.

Japan, which saw real estate prices fall in the 1ate 1980s, has been mired in more than a decade of weak growth compounded now by a prolonged bout of deflation -- falling prices.

Economists view deflation as a far more serious threat than inflation because interest rate changes have only a limited impact once a deflationary spiral begins. America's last bout of deflation occurred during the Great Depression of the 1930s.

"The probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level," the Fed said in Tuesday's statement.

For that reason, the central bank said it believed the "balance of risks" going forward was "weighted toward weakness over the foreseeable future."

At its last meeting on March 18 the Fed had refrained from offering a risk assessment, on grounds there were too many uncertainties in the period before the Iraq war.

Fed prepared to cut

Analysts said that by switching the risk statement toward weakness and noting the possibility of deflation, the Fed was giving a clear signal it was prepared to cut rates further and do whatever else it could to boost growth and keep deflation from setting in.

"The Fed is determined not to repeat the mistake of the Bank of Japan which waited too long to fight deflation," said Sung Won Sohn, chief economist at Wells Fargo in Minneapolis.

On Wall Street, the Dow Jones industrial average initially surged on the prospect of further rate cuts, with the Dow Jones industrial average rising by more than 100 points. However, a wave of profit-taking cut that gain to 56.79 with the Dow closing at 8,588.36.

Holding the funds rate steady means that commercial banks' prime lending rate-- the benchmark for millions of consumer and business loans -- will also remain unchanged at 4.25 percent, the lowest level since May 1959. The prime rate has been at that level since the Fed's last rate cut on Nov. 6.

The end of the war in Iraq hasn't produced an economic boom as some had hoped, and economists now worry that new layoffs could cause consumers to cut spending.

Greenspan last week in congressional testimony expressed optimism about the economy's prospects now that the war is over, but he cautioned that the timing and strength of a rebound remained uncertain.

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