Fed Says Economy Picks Up But Keeps Lid On Interest Rates

The Federal Reserve Open Market Committee (FOMC) Wednesday said that the economy has improved, but kept the benchmark interest rate target at all-time lows, indicating that it is determined to nurture a budding economic recovery by providing liquidity to the financial sector.

Economic activity is “picking up,” the Fed statement said. The statement was a more upbeat assessment of the economy than comments from Federal Reserve Chairman Ben Bernanke last week, warning that the recovery is likely to be anemic.

The central bank also said it intends to extend purchases of $1.45 trillion in long-term government bonds into the first quarter of 2010.  It originally had scheduled those purchases to be completed by the end of the year.

By lengthening the deadline, the Fed is signaling that Bernanke and other members of the committee believe the economic recovery is on firm footing.

Signs of a fledgling recovery have shown up recently in government reports that show the housing industry is stabilizing, retail sales are slowly on the mend and utilization of industrial capacity is increasing.

Consensus projections by economists have forecast U.S. gross domestic product (GDP) growth will hit 2.9% in the third quarter, up from a 1% estimate in July, according to Bloomberg News.

“The bottom is no longer falling out, but the recovery is still at a very early stage,” Mark Gertler, a professor of economics at New York University told Bloomberg, who studied the Great Depression with Bernanke before he became Fed chairman. “There is no need to expand the balance sheet now, but it is a bit too early to begin shrinking it.”

By keeping interest rates steady, the central bank signaled that inflation is not a current threat to the economy, and that the recovery still needs fiscal stimulus.

The Fed lowered the benchmark lending rate to a range of zero to 0.25% at the Dec. 16th, 2008 meeting and has left it unchanged since.  It later adopted a policy of “quantitative easing” authorizing the purchases of the long-term government bonds.

The announcement to stretch the purchase of long-term government bonds was expected by analysts and means the Fed is unlikely to withdraw government funds from the system until at least the second quarter in 2010.

Draining funds from the system now could drive up interest rates on 10-year Treasury notes.  That would likely increase the odds of higher mortgage rates which could crush the housing recovery.

“Probably two-thirds of the committee is concerned that being too quick to embrace the stronger growth story could lead the market to price in sooner rate hikes and tighter financial conditions than they would like,” Michael Feroli, an economist at JPMorgan Chase & Co. (JPM) in New York and a former member of the Fed’s research staff told Bloomberg.

And with unemployment at a 26-year high of 9.7% and forecast to reach 10.1% in the fourth quarter, the central bank has made it clear it’s too early to celebrate, because  “businesses are still cutting back on fixed investment and staffing.”

Some on the committee believe that with millions out of work and ample capacity to increase factory production, the economy has plenty of room to run before inflation becomes a threat.

“The Fed will move gradually and cautiously in reducing its balance sheet next year even as there are further signs of a sustained economic recovery,” UBS AG Securities (UBS) economist Maury Harris wrote in a research note obtained by Reuters.

The steady-as-she-goes approach has been a relief to investors.  Stock markets have surged since bottoming out in March, and the blue chip Dow Jones Industrial Average has gained around 3300 points, or about 51%, as the Fed held interest rates at all time lows.

And it’s unlikely the Fed is going to shock investors by springing a surprise policy change on them anytime soon.

“The Fed has been pretty good about telegraphing what they’re going to do via speeches by the governors at conferences and things like that,” Marc Pado, of Cantor Fitzgerald LP, told The Wall Street Journal. “There’s just been no hint of a policy change lately.”

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