The Fed holds on interest rates

The Federal Reserve decides to leave interest rates unchanged, citing early signs of stabilization in the sagging U.S. economy.

3 min read
The Federal Reserve on Wednesday decided to leave interest rates unchanged, citing early signs of stabilization in the sagging U.S. economy.

The federal funds rate will stay at 1.75 percent--its lowest level since 1961. The funds rate is the interest banks can charge each other for overnight loans; the discount rate is what the Fed charges banks to borrow.

In explaining its decision, the Fed said recent data show encouraging signs of economic improvement.

"Signs that weakness in demand is abating and economic activity is beginning to firm have become more prevalent," the statement read. "With the forces restraining the economy starting to diminish, and with the long-term prospects for productivity growth remaining favorable and monetary policy accommodative, the outlook for economic recovery has become more promising."

But the Fed did caution investors, and said conditions are likely to get worse before they get better.

"The degree of any strength in business capital and household spending, however, is still uncertain. Hence, the Committee continues to believe that...the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future," the statement read.

For the past year the Fed has aggressively reduced rates to boost the economy--lower interest rates encourages businesses and consumers to borrow and spend. The Fed decided to leave rates unchanged in December 2000 and then approved a series of 11 cuts in 2001, including three unplanned decreases.

Recent economic data have indicated that the U.S. economy is in a recession, which is usually defined as two consecutive quarters of negative economic growth.

The Gross Domestic Product (GDP), the value of all U.S. goods and services, grew 1.9 percent in the fourth quarter of 2000, 1.3 percent in the first quarter of 2001, 0.3 percent in the second quarter, and it fell 1.3 percent in the third quarter.

A Wednesday advance release of fourth-quarter GDP shows the economy grew an unexpected 0.2 percent, which may have led to the Fed's decision to hold off for now. The Department of Commerce will release a preliminary version of fourth-quarter GDP on Feb. 28, which may be revised either upward or downward.

Some Wall Street economists interpreted the GDP data as a sign that the Fed is done cutting rates. Merrill Lynch economist Gerald Cohen wrote in a report that the GDP will grow by 5 percent in the second half of this year and the Fed will start to raise rates in late summer.

Others exercise more restrained optimism, saying the economy may not be ready to rebound just yet.

"The future course of GDP growth still depends crucially on the sustainability of consumer spending growth, an area where...substantial uncertainty (remains)," wrote Banc of America Securities economists Peter Kretzmer and Susan Polatz. "However, given the very accommodative monetary policy now influencing demand growth, we continue to expect robust growth in consumer spending over the middle of the year, after a more restrained outcome this quarter."

The Fed took a different stance on interest rates in 1999 and 2000, and raised the funds rate six times for a total increase of 1.75 percentage points to a high of 6.5 percent in May and also hiked the discount rate five times, to 6 percent, an increase of 1.5 percentage points.

The Fed's primary focus is to contain inflation, and its main instrument is interest rates. When it senses the economy is growing at a rate that could ignite inflation, it often raises rates, which increases the cost of borrowing money and can pinch corporate financial activity.

But when the economy seems headed for trouble, the Fed lowers rates. Lowering interest rates makes it less costly for businesses to finance expansion plans and increases the incentive to borrow money, which can spark economic growth. Lower rates can result in more stable stock prices as well, because interest-paying investments become less attractive.

The Fed's policy-making committee meets again March 19, 2002.