Federal Reserve & Interest Rates

The Federal Open Market Committee met this week and to no ones surprise left interest unchanged once again and issued a press release following their meeting.

In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability. 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, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

There have been call from some circles to raise interest rates recently, most notably from former Fed Chairman Alan Greenspan.  While GDP grew once again in the last quarter, signaling the end of the recession, numerous problems still lie ahead for the economy.

The banking system is still in a fragile state, with many financial institutions hoarding cash, still reluctant to lend to consumers whose demand for credit is also well below normal levels.  The housing market, while it has had increased activity as of late, has yet to recover and that could still be years away.

Consumer spending is also way down and many household have increased their savings rate, with an uncertain labor market for the foreseeable future.  The economy is just at the start of the recovery phase but much of the positive GDP growth from last quarter was mostly due to the fact of the increased fiscal spending the government has undertaken over the past year.

It may be as much a year, if not longer before the Fed raises interest rates once again or begins shrinking it’s balance sheet for that matter.  While the Fed has to be careful about timing it’s exist strategy, with the current state of the economy, monetary easing doesn’t appear warranted just yet.

The Federal Reserve has kept interest rates at nearly 0% for some time now and by all accounts it will remain at that level through next year.  Now over a year removed from the beginning of the financial panic, credit markets have yet to recover.

Consumers and businesses are reluctant to borrow and financial institutions are reluctant to lend, even with interest rate at historical lows.  Consumer spending has been stagnant and with demand still low, businesses are loathe to make capital investments.

Throughout the recession, the savings rate of American households continues to climb despite repeated efforts by the government to stimulate consumer spending through stimulus payments and incentive programs.  Although the economy is expected to return to positive growth this quarter, it’s been mainly driven though the government’s fiscal and monetary policy initiatives.

With it’s normal monetary policy tool exhausted, the Federal Reserve has had to use balance sheet growth to expand the money supply.  The federal government has also had to undertake massive budget deficits in order to rescue the financial system.

With the current state of the credit system, talks of exit strategies might be premature at this juncture.  Short term inflation expectations remains low but it is something the government will have to worry about in the long run.

Financial institutions are still trying to de-leverage themselves and hundreds of banks are likely to fail in the next three to four years.  Consumer confidence will also likely remain muted for some time with the labor market expected to take years to recover.

Despite the record growth of the national debt, a number of individuals have cautioned against the government reducing it’s fiscal spending anytime soon or the economy could see a series of fits and starts as it tries to recover.

Federal Reserve Vice Chairman Donald Kohn gave his views on the current economic outlook in a speech on Tuesday.

In broad terms, the data that we have in hand indicate that economic activity turned up in the third quarter. To some extent, the pickup in activity in recent months reflects the dissipation of some of the forces that had been exerting downward pressure on the economy during the preceding several quarters.

Perhaps the most important of these downward forces was the turmoil in financial markets that began in late 2007, which not only tightened credit availability and reduced wealth, but also undermined confidence, especially when conditions took a decided turn for the worse in the fall of 2008.

The stabilization, and more recently the improvement, in risk appetites and financial conditions, in part responding to actions by the Federal Reserve and other authorities, has been a critical factor in allowing the economy to begin to move higher after a very deep recession.

Although the financial system has stabilized somewhat, credit has remained tighter than they would wish.  The Fed still has extensive excess bank reserves on deposit but as economic conditions improve, it is hoped that institutions will lend more freely.

The labor market is still a hurdle that the economy has to get through and while job losses are slowing, the downward trend is expected to continue for a few more months and it could take years for it to fully recover.  Many economists feel that the unemployment rate could remain above 9% mark into 2011.

The housing market also remains a problem for the economy but hopefully as credit conditions improve, that will translate into increased sales activity.  Consumer spending will also likely remain somewhat muted until labor conditions start improving once again but demand has picked up in the past few months.

A lot of people are starting to see the light at the end of the tunnel and hopefully in the months ahead, this view will be re-enforced.