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Fed shifts gears
Central bank leaves rates alone, but alters promise to hold rates steady for "considerable period."
January 28, 2004: 4:45 PM EST
By Mark Gongloff, CNN/Money Staff Writer

NEW YORK (CNN/Money) - Federal Reserve policy-makers held a key interest rate at the lowest level in more than 40 years on Wednesday but dropped a long-standing promise to hold rates steady for a "considerable period," replacing it with a pledge to be "patient" before raising rates.

The central bankers left their target for the federal funds rate at 1 percent, a level last touched in 1962 and not seen on a consistent basis since 1958. The fed funds rate is an overnight bank loan rate that influences many banks' prime lending rates.

But in the closely watched statement accompanying the decision, the Fed dropped its promise to keep rates on hold for a "considerable period," saying instead it could be "patient" with rates. Most economists had expected the Fed to stand pat on rates and the language of its statement.

"They keep fiddling with the language, and the general tone of the directive keeps getting a little less dovish," said Ethan Harris, chief economist at Lehman Brothers. "Being 'patient' sounds a little less like they're keeping rates on hold than a 'considerable period' -- though you'd need to study a dictionary closely to figure that out."

The response on Wall Street was immediate and dramatic -- stocks and bonds reversed earlier gains and fell, with many investors apparently believing the Fed's altered language was a hint the central bank was moving closer to raising rates.

"I think the market's reacting appropriately," said Henry Willmore, chief economist at Barclays Capital. Willmore expects the Fed to begin raising rates at its June meeting, and he was one of the few economists who had predicted the Fed might make some move to prepare the market for a future tightening.

"Previously the market had taken out any risk of a second-quarter tightening by the Fed," Willmore said. "With this statement, we see that's not a risk to be discounted."

Did the markets overreact to the Fed's change in language?

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The yield on the 10-year Treasury note surged from about 4.05 percent to about 4.25 percent immediately after the announcement, causing some anxiety that mortgage rates, which follow the 10-year note, could see a similar jump.

But the bond market calmed down later in the afternoon, with the 10-year yield settling back to about 4.16 percent, still an historically low level. Some Fed watchers suggested the central bank may still hold short-term rates steady for much of the year and that its new language was simply an effort to shake off the words "considerable period," which may have handcuffed it a bit.

"They wanted to give themselves some flexibility, which they didn't have with that language," said Robert MacIntosh, chief economist at Eaton Vance Management.

MacIntosh, who expects the Fed to wait until after the November election to raise rates, noted the central bankers were likely to first take other "baby steps" on the road to tightening, including shifting their assessment of the risk of inflation.

Other economists suggested future speeches and statements by Fed officials -- including Chairman Alan Greenspan's regular testimony before Congress in early February -- would offer other clues about what the Fed means, exactly, by the word "patient."

"I think what people will see is that commentary from Fed officials will sound almost identical to their commentary prior to this meeting," said Harris of Lehman Brothers. "Nothing's really changed at the Fed."

In its statement, the Fed painted a mixed picture of the economy, saying output was "expanding briskly" but that new hiring was "subdued" and that inflation was "muted."

Policy-makers also continued to say that the chances of a dangerous drop in inflation -- which would hurt corporate profitability and economic growth -- are "roughly equal" to the chances for a jump in inflation.

"With inflation quite low and resource use slack, the Committee believes that it can be patient in removing its policy accommodation," the Fed said.

Waiting for turnaround in jobs

The Fed cuts the fed funds rate when it wants to spur economic growth, and boosts it to help ward off inflation.

In response to a recession, terrorist attacks, the three-year bear market in stocks, two wars and the corporate scandals, the Fed has cut the fed funds rate 13 times since the start of 2001, to 1 percent.

Due to a technical problem, the CNN/Money home page, at the time of the Fed announcement, briefly said the Fed had kept its "considerable period" language. We regret the error.

Despite blistering economic growth in the third quarter of 8.2 percent -- and another strong growth rate likely in the fourth quarter -- the labor market's recovery has been sluggish, and the Fed's favorite measure of inflation has slowed down.

While there are plenty of other signs that prices could start rising -- the dollar's value has been sinking, while oil, gold and plenty of other commodity prices have jumped -- most economists believe the Fed won't raise short-term rates, at least until it's seen a few months of solid job growth and signs that inflation is about to hit consumers.

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"I think they'll need to see a lot of job growth, not just one month," said former Fed economist Lara Rhame, now senior economist with Brown Brothers Harriman.

The last time the Fed was in this position, during the "jobless recovery" that followed the 1990-91 recession, it waited until Feb. 4, 1994, to raise rates -- by which time payrolls outside the farm sector had grown by 4.2 million jobs from their bottom in May 1991.

This time around, payrolls bottomed out in July 2003 and have added just 278,000 jobs since. But many economists hope the job market will gather steam this year, which could put upward pressure on inflation.

"If inflation were to slow down some more, that would put off the date of any further tightening," said Willmore of Barclays Capital. "But if it's stable or rising, the Fed will focus more on job numbers. We think the labor market indicators will be fairly strong."  Top of page

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