Federal Reserve lays groundwork for first interest rate hike


(Photo by Richard Drew/AP)

The Federal Reserve spent the past five years driving home a single message: Zero percent interest rates are here to stay. Now it is preparing to change its tune.

The nation’s central bank said Wednesday it will look at a broad swath of indicators – including job market data, inflation expectations and financial developments – as it determines when to raise rates for the first time since the recession hit. The deliberately vague wording is a retreat from the Fed’s concrete promise to leave rates untouched. Though they disagree on when to act – targets range from this year to 2016 – the statement signals the moment has finally come within striking distance.

The Fed has cast the shift as merely a change in semantics, not in official policy. In its statement, the central bank tried to assure investors that rates could remain below historical levels – even if they are no longer at zero.

“The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run,” the statement says.

A survey of Fed officials released Wednesday suggested that after the first hike, interest rates could rise more quickly than previously expected. Four officials believe rates could be at 1 percent at the end of 2015, two more than in December. By the end of 2016, a growing number of officials believe rates could be 2 percent or higher. The Fed believes the normal level for interest rates is 4 percent.

Markets dropped quickly after the announcement and then slightly rebounded, with the Dow Jones and Standard & Poor's down around 0.6 percent a little before closing.

The Federal Reserve began cutting interest rates in fall 2007 as signs emerged overseas of the financial turmoil that would usher in the worst economic downturn in the United States since the Great Depression. It kept slashing over the next year amid domestic bank failures and a crumbling housing market. In December 2008, rates hit zero.

The so-called federal funds rate, which sets the cost at which banks can borrow from each other overnight, influences the pricing of a broad array of business and consumer loans. Mortgage and auto rates plummeted as the Fed kept lowering its benchmark -- the equivalent of flooring the gas pedal in hopes of keeping the economy from veering into a very deep ditch.

But the Fed struggled to convince wary investors that it had no intention of letting its foot off the accelerator any time soon. To reassure markets, the central bank made a series of increasingly definitive promises that it would leave interest rates untouched. Most recently, it vowed not to raise rates at least until the unemployment rate hit 6.5 percent.

Now, the economy is approaching that threshold. The unemployment rate was 6.7 percent in February, and investors have called for more clarity about the Fed’s intentions once the milestone is met.

But there is little agreement over what should happen next. The Fed believes the labor market is steadily healing, but the unemployment rate has fallen faster than officials expected as workers leave the labor force due to retirement and discouragement. Some officials believe the Fed should keep interest rates low until the economy is close to full employment – or even beyond that point – in an effort to recapture those lost workers. Others argue that keeping rates low for too long risks stoking inflation and financial instability.

The Fed’s statement on Wednesday does little to resolve this debate, which is likely to dominate the discussion at the central bank over the next year or longer. Instead, the vague language is designed to give the Fed plenty of flexibility until it has more information about the strength of the recovery.

On Wednesday, it slightly lowered its forecast for economic growth to 2.8 to 3 percent this year and 3 to 3.2 percent next year. However, it predicted the unemployment rate will fall more quickly, reaching 6.1 to 6.3 percent this year and 5.6 to 5.9 percent in 2015. There was little change in its inflation forecast.

The Fed will likely have to alter its language at least once more as the timing of the first rate hike grows closer. The historically secretive institution has embraced transparency in the aftermath of the financial crisis, and Fed officials hope ample warning of any move can help achieve a smooth landing for the economy.

“We’ll do our best to be clear, both in advance and as it’s happening,” San Francisco Fed President John Williams said last month. “We don’t want to give anyone an excuse to pretend they didn’t see it coming.”

The Fed’s policy-setting committee approved the statement 8-1. Minneapolis Fed President Narayana Kocherlakota dissented over concerns that parts of the statement weakened the Fed’s commitment to its 2 percent inflation target.

In addition, the Fed voted to continue reducing the amount of money it is pumping into the economy. The Fed has been buying bonds to help push down long-term interest rates and boost demand from consumers and businesses. Over its past two meetings, the Fed scaled back those purchases by $20 billion to $65 billion. It will cut the amount to $55 billion next month.

Ylan Q. Mui is a financial reporter at The Washington Post covering the Federal Reserve and the economy.
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