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Federal Reserve Pursues Rate Stability

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fed-update-articleFEDERAL-FUNDS-RATE TARGET: 2.25 to 2.50 percent


The Federal Reserve today announced its decision to leave the federal funds rate unchanged, resisting calls to slash interest rates. In choosing to take middle ground between the steady rate increases of the past two years and returning to a looser monetary policy, the Fed has both recent and long-term evidence to consider.

The Fed announcement left the target range for the fed funds rate between 2.25 percent and 2.50 percent. Though lowering rates is often perceived as an easy source of stimulus for the economy, it also poses a risk of inducing inflation. Given recent conditions, the Fed seems to be steering a reasonable course between encouraging economic growth and moderating inflation.

The case for federal funds rate stability

The Federal Open Market Committee (FOMC), the committee of Federal Reserve Board Governors and regional Federal Reserve presidents that also makes decisions on monetary policy, decides when to change the federal funds interest rate. But the FOMC defines its overall mission as striking a balance between encouraging job growth and moderating inflation, so their actions should be viewed based on recent employment and inflation data.

Job growth was up and down during the first quarter but was pretty strong for the most part. The preliminary estimate of first-quarter-GDP growth showed the economy growing at an annual inflation-adjusted rate of 3.2 percent, a solid growth rate that reverses two previous quarters of slowing growth. In short, the economy may not be booming - but after nearly 10 years, the current economic expansion shows no sign of stopping either.

On the inflation front, year-over-year inflation remains moderate; though it has perked up in the past couple months and, disturbingly, oil prices have risen sharply so far this year. While price increases are not yet troublesome enough to warrant an immediate increase in rates, there is just enough of a whiff of inflation in the air to serve as a reminder of the risk of lowering interest rates too hastily.

These mixed signals justify the Fed's wait-and-see mode and, unless the job market or inflation makes a more clearly defined turn, the Fed may well keep rates stable for a while.

Current fed funds rate compared to historical norms

Because the Fed raised interest rates several times over the past couple years, it may be natural for people unfamiliar with its history to assume that rates are relatively high. However, from a historical perspective, the opposite is true.

Over the past 50 years, the average federal funds rate was 5.26 percent - more than twice the recent level of 2.41 percent. One reason the Fed's interest rate was so high over the past 50 years was that inflation was unusually high for much of that period; but even on an inflation-adjusted basis, today's fed funds rate looks low. The average inflation-adjusted federal funds rate over the past 50 years was 1.15 percent compared with today's level of 0.50 percent.

This history suggests that there is still room for interest rates to move higher, even after the increases of the past couple years. Restoring rates to more normal levels would give the Fed more latitude to act the next time an economic slowdown demands attention. For the time being, though, with neither economic growth nor inflation requiring immediate action, the FOMC has opted for a period of rate stability - something the business and investment communities should welcome.

When the Fed meets next on June 18 and 19, they are scheduled to update their economic projections for the months and years ahead. Even if the Fed continues to hold rates steady at that next meeting, those updated projections could provide an early clue to the next direction interest rates will take.


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