After weeks of speculation about what the Federal Reserve would do, its policymakers decided Tuesday not to push up short-term interest rates - for now.
And that decision is proving a mild disappointment to most investors and economists.
The emphasis is on "mild." Analysts had hoped Fed policymakers would react at their Tuesday meeting to signs the economy is growing strongly enough to fuel an uptick in inflation. They didn't. But most economists still expect the Fed to raise rates again before the end of the year.
"It's a mistake to think they're pulling back," says James Annable, chief economist at First National Bank of Chicago. "It's still a good bet that we're going to see higher rates soon, probably within the next six weeks."
Investors also found little to cheer or jeer about. Indeed, for most money managers the news came as a relief after a tense day of waiting. The word arrived just before 2:30 p.m. ET, when a Fed spokesman told reporters the meeting was over and that there would be no further announcement.
Under the Fed's new-in-'94, slightly more open decisionmaking procedures, that amounted to a public declaration that rates remained unchanged.
Stocks rose on the non-news. Higher interest rates tend to make stocks look like less attractive investments and can hurt corporate earnings by slowing the economy, so investors viewed Tuesday's stand-pat decision as a temporary reprieve. The Dow Jones industrial average rose 14 points to 3863. Broader market averages were mixed.
Bond investors took a dimmer view of the Fed's decision. They fear and loathe inflation, which erodes the value of bonds and the fixed stream of interest income bonds pay. News of the Fed's decision fanned fears that the central bank isn't moving quickly enough to put a lid on inflationary pressures by raising rates to slow economic growth. The yield on the benchmark 30-year Treasury bond, which moves in the opposite direction of its price, rose to 7.84%, from 7.79% Monday.
Inflation fears also gave a small boost to gold, sometimes viewed as a hedge against rising prices. The price of gold for October delivery rose to $398.10 an ounce, from $394.50 Monday. The heavily traded December gold contract broke the psychological barrier of $400, surging $3.60 to $401.40 an ounce. Meanwhile, the dollar fell, weighed down by falling bond prices. It dropped to 1.54 German marks, from 1.55 Monday, and 98.15 Japanese yen, from 98.61 Monday.
The Fed's decision left the federal funds rate, which banks charge each other on overnight loans, at 4.63%. The discount rate, which the Fed charges on overnight loans, remains at 4.00%. Since it started pushing up rates Feb. 4, the Fed has bumped up the federal funds rate by 1.75 percentage points, and the discount rate by 1 percentage point.
The decision actually came as little surprise to many economists, who had expected policymakers to wait until key economic data is released in early October. Figures on September inflation, employment and manufacturing strength are due the next two weeks. Those will give the Fed a better idea of whether its rate hikes so far this year are starting to slow the economy, says Kathleen Camilli, chief economist at Maria Fiorini Ramirez Inc., a consulting firm.
"I think in the back of the Fed's mind is the thought that maybe the slowdown they've been waiting for is just around the corner," Camilli says. "I think they're still worried about (raising rates) at a time when the economy is already slowing down."
Ideally, the Fed would like to see growth in gross domestic product slow to a 2.5% to 3% annual rate. That's roughly in line with what most economists think is the maximum rate of growth that can be achieved over an extended period without heating up inflation. By contrast, GDP grew at a 3.8% rate the second quarter, a pace which may have been been matched or exceeded the third quarter.
The Fed's dilemma: While previous rate hikes should be slowing growth, there's little sign of that happening. Industrial production rose 0.7% in August, a sign the manufacturing sector is still running strong. Capacity utilization, which measures the amount of productive slack left in the economy, has risen to levels that traditionally signal demand is so strong inflation is bound to rise.
There are, however, preliminary signs the economic growth is starting to flatten out:
-- Higher mortgage rates are beginning to hobble the housing industry. Existing home sales fell 1.8% in August from July, the National Association of Realtors reported Monday.
-- The unemployment rate, after falling sharply earlier this year, has hovered near 6% for four months.
Such signs justify the Fed's decision, says Andrew Brimmer, a former Fed governor and a director of Gannett, which owns USA TODAY. "I think the Federal Reserve has done its job," he says. The Fed indicated it would put policy moves on hold for a while after it raised rates Aug. 16. "They didn't see any reason to change that stand, and I see no reason to disagree with that," Brimmer says.
But like most economists, Brimmer still thinks the Fed will raise rates one more time by the end of the year - if only as an extra safeguard against stronger-than-expected growth. Some analysts say Fed policymakers may have given Fed Chairman Alan Greenspan leeway to act on his own before their next meeting Nov. 15. Greenspan did that in April, when he pushed up the federal funds rate a quarter point.
He could act even though another upward push on rates might become an issue in the Nov. 8 congressional elections. Fed policymakers "are not all that politically independent, but they don't worry much about that kind of timing," Annable says.
Bottom line: Most observers believe the Fed will not tolerate an upturn in inflation. "If the Fed really wants to hold down prices, it's going to have to take rates higher, maybe much higher," says Annable. "I think that's exactly what they want to do."
Market watchers also believe another rate hike is inevitable. "This just prolongs the uncertainty that's been clouding the market," says Charles Crane, director of research at Spears Benzak Salomon & Farrell, which manages $2.8 billion.
Stocks likely will be volatile as investors scrutinize every economic report to determine whether inflation is heating up, or if the economy is slowing. Either way, it will be rough going for stocks, Crane says. Higher inflation would give the Fed reason to boost rates, making stocks less attractive. But a more sluggish economy could hurt corporate earnings. Crane says uncertainty could push the Dow back to its April low of 3600 in the next few weeks.
"We're in for a rough fourth quarter," adds Larry Rice, strategist at Josephthal Lyon & Ross. Rice points to a number of warning signs:
-- The number of stocks hitting new lows every day is swelling while new highs are dwindling.
-- Though the Dow is less than 3% from an all-time high, broader market averages are far from records.
-- October is a treacherous month for stocks: The three worst single-day stock losses ever occurred in October.
"These are all signs that this bull market is overextended," Rice says. Rice predicts the Dow industrial average will fall 9%, to about 3500, in the next few months.
Stocks could get a temporary lift from third-quarter, corporate earnings reports, which start coming out next week. Earnings are expected to be up 20% from a year earlier.
But, says Elaine Yager, technical analyst at Herzog Heine Geduld, "if inflation perks up and rates go higher" as the Fed forces them up, "the risk in stocks would be greater."
