Fed expected to leave rates unchanged

WASHINGTON -- A key short-term interest rate is at a 45-year low, and Federal Reserve policy-makers are expected to keep it there when they meet Tuesday.

Fed officials, however, will certainly spend time discussing what, if anything, they can do to stop long-term rates from rising and derailing the economy.

Only this spring did Federal Reserve chairman Alan Greenspan and his colleagues draw praise for cleverly manipulating market expectations with talk of deflation, which is a sustained fall in prices.

Now, they are criticized for misleading the bond market and causing a big run-up in long-term rates over the past month.

For that reason, many analysts see the Fed meeting as an opportunity for the central bank to correct the botched signals and to calm the jittery bond market.

"We are facing a dangerous situation with the threat that interest rates will go up so fast that it will choke off the recovery," said economist David Jones, author of four books on the Fed. "The Fed has to state more clearly what its intentions are."

At its last meeting, on June 25, the central bank reduced its target for the federal funds rate, the interest that banks charge each other on overnight loans. The rate fell by one-quarter of a percentage point, to 1 percent, the lowest since July 1958.

In response, commercial banks dropped the prime rate, the benchmark for millions of short-term consumer and business loans, to 4 percent. Not since 1959 had this rate fallen so low.

But rates on longer-term loans actually rose after the Fed's action. The bond market was disappointed that policy-makers had not moved more boldly given the Fed's talk about deflation.

A Fed statement after its May 6 meeting cited that threat, leading to a sharp rally in the bond market that drove long-term interest rates to the lowest levels in decades.

The Treasury's 10-year note, a determining factor in mortgage rates, fell to 3.1 percent in June and 30-year mortgages dipped to 5.21 percent, rates unseen in more than four decades.

Then came the Fed's quarter-point cut on June 25, rather than the hoped-for half-point move. Since then, long-term rates have climbed. The 10-year Treasury reached 4.41 percent on Aug. 1; last week, rates on 30-year mortgages stood at 6.43 percent.

This jump in long-term rates has raised fears that a pillar of the economy over the past two years, consumer spending on big-ticket items such as houses and automobiles, could come to a halt, especially in light of the recent falloff in mortgage refinancings. They have helped support consumer spending by giving people more disposable income.

While concerned about higher rates, many analysts believe the bond market will calm down if the Fed on Tuesday is convincing that it is ready to keep short-term rates low for a considerable time.

"My expectation is that the Fed will stand pat for at least a year," said Sung Won Sohn, chief economist at Wells Fargo in Minneapolis. He noted that the central bank would rather not raise rates in the midst of a presidential campaign.

If the Fed succeeds in conveying that message, many analysts believe that long-term rates should stabilize around current levels.

Sign on mortgage rates

In a hopeful sign, the yield on 10-year Treasury bonds retreated at the end of last week to 4.27 percent, an indication that mortgage rates also will come down.

Many analysts believe that 30-year mortgages will probably remain around 6 percent to 6.5 percent for the rest of this year.

But the run-up in rates so far will affect interest-rate sensitive sectors such as housing and trim overall economic growth, analysts said.

David Wyss, chief economist at Standard & Poor's, said he believes the economy will grow by about 4.1 percent next year, down about 0.3 percentage point from his previous forecast, due to the rise in interest rates. But that would still be a substantial improvement from the 2.4 percent growth he expects this year.

Such growth would supply enough impetus to start generating new jobs and lower the unemployment rate, Wyss said. He predicted that rate, now at 6.2 percent, will be around 5.7 percent by the time of the presidential election in November 2004.

That probably would encourage a Bush administration concerned about the so-far jobless recovery. President Bush will meet with his top economic advisers on Wednesday to discuss what more needs to be done to boost economic growth.