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Like the economy, the Fed is still treading water

June 19, 2013

| MoneyRates.com Senior Financial Analyst, CFA

The release of the latest Federal Open Market Committee (FOMC) statement caused some immediate market volatility, despite containing no surprises.

In fact, the brief recap of the FOMC meeting concluded today was virtually the same as the last few statements. Key components include:

  1. A mixed view of the economy, noting some signs of progress but also the continuing constraint of fiscal policy.
  2. A stimulus program including $40 billion of mortgage-backed security and $45 billion of long-term Treasury purchases each month, along with keeping the federal funds rate between 0 and 0.25 percent.
  3. An unemployment rate target of 6.5 percent.
  4. An inflation target of 2 percent, with half a percent of leeway over that amount before the Fed would consider anti-inflation policy changes.

While the Fed statement is clear about keeping the Fed funds rate in place until its stated unemployment or inflation thresholds are reached, the one area of wiggle room the Fed has maintained is with respect to those security purchases. Here, the Fed's position has been that it is ready to adjust the pace of its purchases in response to labor market or inflation changes. This one area of ambiguity continues to be the subject of much market speculation.

Impact on the federal funds rate

As noted above, the FOMC statement reiterated a commitment to keeping the federal funds rate in the extremely low range of 0 to 0.25 percent. Barring any flare-up of inflation, the slow decline in the unemployment rate suggests that this policy will remain in place at least beyond the end of this year.

Longer-term interest rates, such as bond yields and mortgage rates, are less directly controlled by the Fed. The Fed's policies of purchasing mortgage-backed and Treasury securities help influence these rates lower, but ultimately they are set by market forces. Those rates have been on the rise lately, as economic improvement has the markets anticipating an end to the Fed's aggressive purchase programs.

Outlook for interest rates

Since the Fed's purchase programs are slated to scale back as the economy improves, the direction of long-term interest rates will depend on the progress the economy makes in the months ahead. So far, the economy has contiued to demonstrate growth, but has yet to break out of the sluggish pace that has characterized the past four years. A sign of clear economic improvement, such as monthly employment gains in excess of 200,000, would be likely to accelerate the rise in long-term rates.

While long rates have already begun to drift higher, a meaningful improvement in savings account rates and other deposit rates seems further off. These are short-term rates, and thus more closely anchored to the federal funds rate. Also, they are less directly driven by market forces, and thus less likely to rise in anticipation of economic improvement. These bank rates are more likely to rise after, not before, stronger growth takes hold.

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