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Fed Hints That Rate Hike Is Unlikely
Investors Cheered By Policy Shift

By Nell Henderson
Washington Post Staff Writer
Thursday, March 22, 2007

The Federal Reserve left interest rates alone yesterday -- surprising nobody.

But the central bank did tweak the language of a statement it put out to suggest that it isn't likely to raise rates anytime soon, producing a giddy reaction on Wall Street, which had been pining for good news.

The Dow Jones industrial average gained 159.42 points, to close at 12,447.52, completing the blue chips' best three-day rally in more than two years. So far this year, the Dow is down slightly, while the broader Standard & Poor's 500-stock index and the Nasdaq composite yesterday moved into positive territory.

"The market just celebrated like the Fed had announced they were cutting rates," said Al Goldman, chief market strategist at A.G. Edwards & Sons. That was a welcome message to traders shaken by the Feb. 27 plunge in stock prices and worried since by turmoil in U.S. mortgage markets, he said. "Three weeks ago, the markets thought the world was coming to an end."

However, investors are wrong if they think the Fed is saying it's about to lower interest rates, Goldman and other analysts said. Rather, the statement the central bank put out suggests that it has opened the door to lowering rates if the economy deteriorates unexpectedly, giving itself the flexibility to respond as needed in a more uncertain environment.

"The odds have shifted toward an ease" in rates, said Ethan S. Harris, chief U.S. economist at Lehman Brothers. He attributed the change to concern about how the economy will be affected by rising mortgage delinquencies and home foreclosures, and the tightening of lending standards that has resulted. "It's something the Fed has to be nervous about."

"Easy lending standards artificially propped up the housing market last year. The tightening of standards this year is going to constrain activity," Harris said. "No one knows the scale of the shift. It is a big uncertainty in the outlook."

So far, the Fed sees the economy -- outside the struggling housing and automobile industries -- as generally healthy, with low unemployment and solid job growth in health care, education, finance, travel and other services.

Fed policymakers, in a statement released after their two-day meeting, held to their forecast that the economy will do fine in coming months, expanding at a moderate pace despite the housing slump.

And they emphasized that they remain more worried about inflation than about the economy's strength. The Fed forecasts inflation to drift lower but said its "predominant policy concern remains the risk that inflation will fail to moderate as expected."

But the Fed dropped language it had used previously to signal that it was more likely to raise interest rates to curb inflation than to cut them to boost growth.

Instead of referring to the possibility of further rate increases, the Fed statement said, "Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth."

Many investors read that change as a sign that the Fed is as likely to cut interest rates as raise them in coming months.

The Fed's top policymaking committee voted unanimously to leave its overnight rate at 5.25 percent, where it has been since June. The rate influences many other short-term rates, such as those on credit cards and home-equity loans.

Long-term interest rates, such as those on mortgages, are determined by global capital markets. Those rates have fallen in recent weeks. The rate on a 30-year mortgage, for example, averaged 6.14 percent last week, down from 6.30 percent a month earlier, according to mortgage company Freddie Mac.

Some investors had hoped that the Fed might lean more strongly toward cutting interest rates to soothe financial markets. But policymakers see no reason to lower their benchmark rate when mortgage rates are falling and businesses still find cheap credit available. Moreover, lowering borrowing costs might spur inflation -- the last thing the Fed wants to do when price increases are already uncomfortably high.

Inflation has fluctuated in recent months along with oil prices. After volatile food and energy prices are stripped out, leaving the "core" rate, consumer prices rose 2.7 percent in the year ended in February, the Labor Department said Friday. That's lower than the recent peak of a 2.9 percent annual rate in September but still too high for the Fed.

If the economy softens a little more, that would make the Fed's job easier by lowering price pressures. But policymakers also don't want the economy to weaken too much and slide into a recession.

The shift in the Fed statement also reflects Chairman Ben S. Bernanke's preference for providing the markets with fewer signals about the policymakers' likely next move on interest rates and more information about their economic forecasts. That leaves it to investors to infer how the bank will respond to changes in the outlook.

By dropping its earlier references to possible rate increases, "the Fed is feeding into the expectation that if things do get bad, they'd ease" rates, said Laurence G. Kantor, managing director of Barclays Capital. "That's good for the stock market and good for the bond market."

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