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Fed Keeps Rates on A Level, Low Course

Recovery Signs Don't Sway Policymakers

By John M. Berry
Washington Post Staff Writer
Wednesday, August 13, 2003; Page E01

Although the U.S. economic recovery appears to be gaining strength, Federal Reserve officials decided yesterday to keep their target for overnight interest rates at the extremely low level of 1 percent and said they expect to keep it there "for a considerable period."

But the officials did not say how long that period might be. Some analysts and investors said they think it will stretch at least until next spring, while others say the Fed could keep its target at 1 percent until 2005.


Fed Chairman Alan Greenspan and his Fed colleagues have said repeatedly in recent months that they do not want the nation's inflation rate to get too near zero. (Larry Downing -- Reuters)

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While the Fed controls the overnight rate, the markets determine the level of longer-term rates, which have risen sharply in the past two months. For instance, yields on 10-year U.S. Treasury notes, which heavily influence fixed home mortgage rates, are more than a percentage point higher than they were in early June.

Economist James Glassman at J.P. Morgan Securities in New York said one reason longer-term rates have surged is that many investors believe the Fed will raise its target as soon as economic growth picks up more strongly, as it has done in the past.

The key reason for Fed officials to make such a public commitment on rates yesterday was their concern that inflation could become "undesirably low" in the months ahead even if economic growth accelerates to an annual rate of 4 percent or more next year, as they have forecast.

Fed Chairman Alan Greenspan and his colleagues have said repeatedly in recent months that they do not want the nation's inflation rate, which has been running at about a 1 percent annual rate or less, to get too close to zero. If it did, some sort of shock to the still somewhat weak economy, such as another terrorist attack in this country, might cause the broad level of prices to fall. Such a condition, known as a deflation, could do severe damage to the economy and make it extremely difficult for the central bank to cut interest rates enough to help it recover.

The central bank's top policymaking group, the Federal Open Market Committee, noted in its statement after the meeting that "business pricing power and increases in core consumer prices remain muted." And while the group said the chance of "an unwelcome fall in inflation" is "minor," it is enough of a possibility that the officials want to do whatever is necessary to keep it from happening.

One reason the group cited for its confidence that economic activity is improving is the strong growth in productivity, the amount of goods and services produced for each hour worked. But for a Fed concerned about falling inflation, and for millions of unemployed American workers, productivity gains have become a two-edged sword.

For a year and a half, businesses have been able to increase their production while reducing the number of hours worked by their employees. In the April-June period, for instance, productivity shot up at a 5.7 percent annual rate in the non-farm portion of the economy. That was such a hefty gain that employers were able to increase workers' pay and benefits and still see their labor cost per unit of production decline substantially.

While that's good for employed people, it also means companies have been able to produce more while continuing to cut jobs. The unemployment rate rose to a nine-year high of 6.4 percent in June; it dropped to 6.2 percent in July only because about half a million people gave up looking for work.

"We expect the labor market will be sufficiently dismal to prevent the Fed from raising rates for some time, particularly because the longer the unemployment rate remains above 6 percent, the greater the downward pressure on inflation in the economy," said economist Joseph Abate at Lehman Brothers Inc. in New York.

The economy grew at a 2.4 percent annual rate in the second quarter, and Abate expects the rate to jump to about 4 percent in the second half of the year. But he also expects such strong productivity growth that the jobless rate will reach 6.6 percent before the year is out and stay above 6 percent next year.

In this environment, with labor costs falling, "we see inflation continuing to drift lower. Essentially what we are seeing here is the dark side of the productivity revolution. Firms are forcing more efficiency out of their workers rather than increasing their head count. And that is what is worrying the Fed," Abate said. He and a number of other economists also said the risk is that there is enough slack in both labor and product markets that inflation could come down even more than expected.

Meanwhile, the rise in longer-term rates is seen by many forecasters as a restraining force on economic growth later this year and next year.

"Rising rates will slow home price appreciation, curb construction and end the cash-out refinancing boom," Abate said. "Our rough calculations suggest that after adding nearly a full percentage point to growth last year, if maintained, the current level of rates could be a similarly sized drag on growth over the next 12 months."


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