Poised for a ‘sym­bolic’ shift

Ef­fect of boost in a key in­ter­est rate would be more psy­cho­log­i­cal than prac­ti­cal

Los Angeles Times - - MONDAY BUSINESS - By Jim Puz­zanghera jim.puz­zanghera@la­times.com

WASH­ING­TON — The re­cov­ery from the Great Re­ces­sion has gen­er­ated solid stretches of eco­nomic growth and job cre­ation, but has failed to im­press Fed­eral Re­serve pol­i­cy­mak­ers enough to pro­vide a key val­i­da­tion of the econ­omy’s strength — an in­ter­est rate in­crease.

That is poised to change as cen­tral bank of­fi­cials sig­naled that they could raise their bench­mark rate as early as this week’s pol­i­cy­mak­ing meet­ing, though an­a­lysts don’t ex­pect a move un­til at least Septem­ber.

The last time the Fed raised the rate was in mid-2006, a year and a half be­fore the start of the worst re­ces­sion since the Great De­pres­sion.

As the econ­omy de­te­ri­o­rated, Fed pol­i­cy­mak­ers ratch­eted the rate down from 5.25% to near zero in De­cem­ber 2008 in an at­tempt to stim­u­late growth. It has been there ever since.

De­spite an un­even re­cov­ery, the econ­omy is much stronger to­day, jus­ti­fy­ing a rate in­crease. But the first one would have more of a psy­cho­log­i­cal than prac­ti­cal ef­fect be­cause the Fed prob­a­bly will in­crease the rate’s tar­get level by only 0.25 per­cent­age point, a small move.

“At the end of the day, it re­ally is more sym­bolic,” said Diane Swonk, chief econ­o­mist at Me­sirow Fi­nan­cial. “It’s go­ing to be an ac­knowl­edg­ment of the econ­omy’s strength. It’s not to com­bat in­fla­tion. It’s not to com­bat an over­heat­ing econ­omy.”

Fed Chair­woman Janet L. Yellen has said pol­i­cy­mak­ers would de­cide when to raise the in­ter­est rate based on an as­sess­ment of eco­nomic data. Even af­ter the ini­tial in­crease, the rate would prob­a­bly rise slowly over sev­eral years to avoid stalling the econ­omy, she said.

The strat­egy is known as “lower for longer” and shows how cen­tral bank of­fi­cials are plan­ning to move de­lib­er­ately to avoid slow­ing the econ­omy.

“This is a Fed that’s not go­ing to do any­thing un­til it sees the whites of the eyes of a self-sus­tain­ing re­cov­ery,” Swonk said.

Here are some com­mon ques­tions about in­ter­est rates and how the cen­tral bank ma­nip­u­lates them to try to help the econ­omy:

Ex­actly what in­ter­est rate is the Fed look­ing to raise?

When peo­ple talk about the Fed rais­ing in­ter­est rates, they are re­fer­ring to the fed­eral funds rate. Banks are re­quired to hold a set amount of re­serves at the Fed. Those re­serves are known as fed­eral funds.

The re­serves fluc­tu­ate daily. So banks that have a sur­plus can lend the money overnight to banks with less than the re­quired amount of re­serves. The rate at which banks make those loans is the fed­eral funds rate.

How does the Fed con­trol the fed­eral funds rate?

The 12-mem­ber Fed­eral Open Mar­ket Com­mit­tee, which in­cludes the seven mem­bers of the Fed’s board of gov­er­nors, votes to set a tar­get for the fed­eral funds rate based on eco­nomic con­di­tions.

Nor­mally the tar­get is a spe­cific in­ter­est rate. But since De­cem­ber 2008, the fed­eral funds tar­get has been a range — zero to 0.25% — be­cause the Fed wanted to get the rate as low as pos­si­ble with­out caus­ing prac­ti­cal prob­lems that would come with pay­ing no in­ter­est on bank re­serves.

The daily fig­ure, known as the ef­fec­tive rate, has fluc­tu­ated from 0.07% to 0.22% since then.

Why does the Fed ma­nip­u­late the fed­eral funds rate?

The Fed moves the rate up or down to try to keep the econ­omy run­ning smoothly. Its ef­fort is part of the man­date from Congress to en­act poli­cies that pro­vide max­i­mum em­ploy­ment, sta­ble prices and mod­er­ate longterm in­ter­est rates.

If the econ­omy is strug­gling, the fed­eral funds rate is re­duced to lower bank bor­row­ing costs in hopes of stim­u­lat­ing ac­tiv­ity. If the econ­omy is over­heat­ing, the rate is in­creased to make bor­row­ing more ex­pen­sive and keep in­fla­tion from ris­ing too much.

One of the most no­table rate changes came in 1980-81 when Fed pol­i­cy­mak­ers raised the tar­get as high as 20% to curb run­away in­fla­tion. Con­versely, the Great Re­ces­sion spurred the Fed to lower the tar­get rate for the first time to what’s known as the zero lower bound — from zero to 0.25%.

The last time the Fed raised the rate was in June 2006, to 5.25%. It was the last of 17 in­creases dur­ing a two-year pe­riod as the Fed tried to re­duce up­ward pres­sure on prices while the econ­omy was ex­pand­ing.

How does the fed­eral funds rate af­fect other in­ter­est rates?

Although the fed­eral funds rate ap­plies only to short-term lend­ing be­tween banks, it af­fects other bor­row­ing costs and, there­fore, has be­come a bench­mark for con­sumer and busi­ness loan rates.

Bank ex­ec­u­tives as well as in­vestors also pay close at­ten­tion to the Fed’s views on the econ­omy and tend to ad­just their busi­ness plans ac­cord­ingly.

For ex­am­ple, the so­called prime rate is set by com­mer­cial banks, sup­pos­edly for their best cus­tomers. It is used to de­ter­mine in­ter­est rates for credit cards, car loans, small busi­ness loans and home eq­uity lines of credit.

The Fed has no di­rect role in set­ting the prime rate, but it notes that “many banks choose to set their prime rates based partly on the tar­get level of the fed­eral funds rate.”

His­tor­i­cally, the prime rate has been three per­cent­age points higher than the fed­eral funds rate, so when the Fed makes a change, the banks usu­ally fol­low.

When the cen­tral bank raised the fed­eral funds rate 0.25 per­cent­age point in June 2006, many banks raised their prime rate by the same amount. And when it cut the bench­mark rate 0.75 per­cent­age point to near zero in De­cem­ber 2008, banks low­ered their prime rate to 3.25% from 4%.

Does the fed­eral funds rate af­fect mort­gage rates?

The fed­eral funds rate has less of a di­rect ef­fect on mort­gage rates, which are longer term and driven more by sup­ply and de­mand in the mort­gage mar­ket.

But the Fed’s in­ter­est rate de­ci­sions and other ac­tions can move mort­gage rates. Mort­gages are of­ten pack­aged into se­cu­ri­ties that are bought by in­vestors. The Fed can in­flu­ence de­mand in that mar­ket by pur­chas­ing those se­cu­ri­ties.

To help the hous­ing mar­ket re­cover af­ter it crashed in 2007, the Fed launched a con­tro­ver­sial ef­fort known as quan­ti­ta­tive eas­ing that in­volved pur­chas­ing hun­dreds of bil­lions of dol­lars in mort­gage­backed se­cu­ri­ties and Trea­sury bonds. That helped to bring down mort­gage rates.

Also, some an­a­lysts said, long-term rates ef­fec­tively re­flect the way that a se­ries of short-term in­ter­est-rate changes are go­ing. So a num­ber of in­creases in the fed­eral funds rate could send mort­gage and other longer-term rates higher.

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