Fed holds line amid conflicting demands for action

McClatchy NewspapersSeptember 21, 2010 

WASHINGTON — The Federal Reserve left its benchmark lending rate unchanged Tuesday, announcing no new plans to purchase bonds to bolster the sluggish U.S. economy but cracking the door open a bit further to take such action if necessary.

The rate-setting Federal Open Market Committee decided to leave the federal funds rate where it's been since December 2008, in a range of zero to a quarter of a percentage point. This ensures that the prime rate, which banks charge their best customers, will remain unchanged.

Ahead of Tuesday's action, financial analysts were sharply divided on whether the Fed should be doing more to boost a flagging recovery. Some experts argued that the Fed should expand its balance sheet by purchasing bonds to stimulate the economy.

Before the economy began slowing over the summer, the Fed was ending its purchases of mortgage bonds to support the economy.

These purchases are part of a strategy called quantitative easing. It amounts to increasing the supply of money by creating an account at the Fed to buy assets such as mortgage bonds or government bonds. In theory, by buying up these assets and driving down their yield, or return to investors, the Fed is prodding banks to lend more to consumers and businesses.

After the summer slowdown, the Fed announced that rather than end its asset purchase program, it would reinvest earnings from maturing mortgage bonds into long-term Treasury bonds.

That move was a compromise, neither growing nor shrinking the Fed's massive holdings, which at one point reached $2 trillion.

Critics of quantitative easing by the Fed fear that inflation could become rampant once the economic embers reignite, because the increased supply of money dilutes the strength of the dollar.

Tuesday's statement skirted the issue directly, instead noting that the Fed is prepared to act aggressively if it thinks the economy is slowing too much.

"The committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate," the Fed said in a statement.

The Fed also signaled that it expects interest rates to remain low for an unusually long period, but it changed its statement language slightly to reflect a growing risk of deflation, or the fall in prices across the economy. Deflation is unwelcome because businesses and consumers postpone spending on the expectation that prices will fall even further.

"The FOMC in essence is setting the stage for further action if current trends continue. Indeed, by November, we believe that the evidence will continue to cumulate of very weak growth and continued disinflationary pressures," Brian Bethune, the chief U.S. financial economist for forecaster IHS Global Insight, said in a research note.

At its meeting Nov. 2-3, the committee is expected to review economic projections. Those usually are made public three weeks later, when minutes of the meeting are released.

Tuesday's statement didn't paint a pretty picture of today's economy.

"Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts are at a depressed level. Bank lending has continued to contract, but at a reduced rate in recent months," the Fed statement said.

The pace of recovery, the Fed said, "has slowed in recent months," and "economic recovery is likely to be modest in the near term."

Financial analysts expect the Fed to keep its benchmark-lending rate at or around zero for quite some time.

"We do not see the Fed taking the first step to hike rates for at least a year and, given the outlook for unemployment, we believe the probability is growing that this move does not occur until sometime in 2012," forecaster RDQ Economics in New York said in a research note that pointed to record gold prices as a signal of market discomfort with more Fed purchases. "In our judgment, any action to ease monetary policy later in the year would be a significant mistake."

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