Fed: Economy better, rates to stay low

By Chris Isidore, senior writer


NEW YORK (CNNMoney.com) -- The Federal Reserve said Wednesday it sees further signs of improvement in the U.S. economy, but not enough to start raising its key interest rate from near 0% anytime soon.

The Fed's statement Wednesday once again spoke of a U.S. economy now in recovery, stating that "economic activity has continued to strengthen and that the labor market is beginning to improve."

But the central bank made little change in its language used to describe the outlook for its policy, saying it expects that economic conditions will "warrant exceptionally low levels of the federal funds rate for an extended period," as it has at every meeting since June of last year.

The fed funds rate, the central bank's key overnight lending rate, is a benchmark used to set interest rates on a wide variety of consumer and business lending.

In December 2008, the Fed cut the rate to near 0% in an effort to spur economic activity, and has left it there ever since.

chart_fed_rate.gif

The promise of keeping the rates low for an "extended period" again drew a dissent from Kansas City Federal Reserve President Thomas Hoenig, who argued that such a forecast could feed the growth of future asset bubbles, like the housing bubble that followed the Fed's most recent course of very low rates early in the last decade.

But the other Fed policymakers said they are still concerned that the recovery will stay modest in the near term and therefore will need the help of cheap money to get fully back on track.

"Investment in nonresidential structures is declining and employers remain reluctant to add to payrolls," the Fed cautioned. "Housing starts have edged up but remain at a depressed level."

Despite those cautions, the Fed did see some notable signs of improvement. It now says the labor market "is beginning to improve," a change from its previous language that said the jobs picture was "stabilizing."

It also heralded improved business spending on equipment and software, which it said has "risen significantly." Spending by consumers is also showing signs of improvement, although the Fed cautioned that it remains constrained by "high unemployment, modest income growth, lower housing wealth, and tight credit."

Even some economists who thought there might be a change in the Fed's promise of low rates into the future weren't overly shocked that the language remained the same once again.

Robert Brusca of FAO Economics said market turbulence that followed the downgrades this week of the sovereign debt ratings of Greece, Spain and Portugal made this the wrong time for the Fed to further shake up markets.

"It may have been an environment that just looked too risky to accommodate a change in this key wording," he said.

Other economists said the Fed is right to remain on hold, given the broad weakness that still exists in the labor and housing markets.

John Silvia, chief economist with Wells Fargo Securities, projects the Fed will stay on hold at least through the November meeting, if not into 2011.

"The Fed feels more comfortable with the recovery, as we all are. But the pace of the recovery is still disappointing," said Silvia. "If housing is at depressed levels and hiring is still weak, what's going to happen if they start to raise rates?"

But other economists are worried that the low rates and the trillions of cash that the Fed has pumped into the economy through various programs will feed inflation and a new asset bubble. Raising rates and pulling cash out of the economy are the tools the central bank typically uses to keep prices in check.

Bruce McCain, chief investment strategist at Key Private Bank in Cleveland, said even with the economic weakness, it would be safer for the Fed to start taking the first steps to raise rates, including more hawkish language in its statement.

"We do see an anemic recovery, but there are price pressures starting to build in the system," said McCain. "If they wait until they absolutely have to move on inflation, it could be too late." To top of page

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