-->Fed Holds Bank Rate at 1%, Sees Signs of Strength, No Inflation

Aug. 12 (Bloomberg) -- Federal Reserve policy makers voted to keep the benchmark U.S. interest rate unchanged, encouraged by signs that the lowest borrowing costs in 45 years may be helping the expansion to accelerate and prevent a further slowing of inflation.

Members of the Federal Open Market Committee left the overnight bank lending rate at 1 percent, the lowest since July 1958. They again split their outlook for growth from the inflation forecast.

''The Committee continues to believe that an accommodative stance of monetary policy, coupled with still-robust underlying growth in productivity, is providing important ongoing support to economic activity,'' committee members said in a statement following the meeting. ''The evidence accumulated over the intermeeting period shows that spending is firming, although labor market indicators are mixed.''

The central bankers signaled they are still concerned that prices are rising at an ever-slower pace, suggesting rates will remain on hold for some time.

''Business pricing power and increases in core consumer prices remain muted,'' committee members said. ''The risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances the committee believes that policy accommodation can be maintained for a considerable period.''

The decision to leave policy unchanged was expected by all 95 economists surveyed by Bloomberg News. The U.S. economy appears to be expanding at a faster pace, just as Fed officials have forecast.

Partly because of that, the yield on 10-year Treasury notes is up more than a percentage point from 3.25 percent the day before the last Fed rate decision on June 25, and the average yield for investment grade corporate bonds of similar maturity has risen by almost a full percentage point, to 4.823 percent from 4.023 percent.

Gross domestic product rose at a better-than-expected 2.4 percent annual rate in the second quarter, powered by consumer purchases, a rise in business investment, and the biggest increase in defense spending since the Korean War in 1951.

U.S. service industries, the largest part of the economy, reported the broadest growth in six years last month, and manufacturing, one of the hardest hit parts of the economy, expanded for the first time since February. Consumer confidence rose, and chain retail store sales increased 4.3 percent in July, the biggest gain in 13 months.

Jobless Recovery

Still, growth isn't strong enough to boost hiring. The economy lost another 44,000 positions last month, and some 1.03 million jobs have disappeared since the recession ended in November 2001.

''We have all these tentative signs that the economy has turned,'' said Kathleen Camilli, an economist at Credit Suisse Asset Management in New York. ''It remains to be seen what sector of the economy is going to be responsible for the turn'' in employment.

The economy needs to create about 100,000 jobs a month to keep up with growth in the labor force. To this point, companies have been meeting demand by increasing the output of the workers they have, rather than hiring.

Productivity, a measure of how much an employee produces for every hour of work, rose from April to June at a 5.7 percent annual rate. By producing more with less, companies are saving money. Unit labor costs fell 2.1 percent in the quarter and are down 1 percent in the last year.

Disinflation

That helps boost corporate bottom lines -- earnings for the Standard & Poor's 500 Index rose 9.7 percent in the second quarter -- which may lead to increased hiring.

It may also mean companies have more room to cut prices in an effort to compete. That's another worry for the Fed, as the rate of price increases in the U.S. has continued to fall.

The personal consumption price index, a measure of inflation followed by the central bank, rose just 0.9 percent in the second quarter, down from a 2.7 percent rate of increase in the first three months of the year.

Any kind of shock might push the U.S. into deflation, a general, sustained fall in prices. That likely would lead to a rise in bankruptcies and defaults, leading the economy into recession.

Until growth picks up enough to push price indexes higher, Fed officials have said they are unlikely to raise rates, and will keep open the possibility of lowering them further.

''A very low positive measured rate of inflation, say, 1/2 percent to 1 percent per year, is undesirable and implies a need for highly accommodative monetary policy,'' Fed Governor Ben Bernanke said in a speech last month.

Given how much productivity has risen, Bernanke also said inflation might fall another 0.5 percentage point even if the economy grew at 4 percent in 2004.

Rising Rates

''More than a few traders are hoping the FOMC gets its statement worded just right,'' said David Gilmore, a partner at Foreign Exchange Analytics in Essex, Connecticut. The central bank must ''convince the market that yields are far more justified at or near the 45-year lows of early June than they are at current levels.''

Many on Wall Street blame Fed officials for sending confusing signals about their intentions. Prior to the June meeting, central bankers had openly discussed the possibility of using alternative policy options, including the purchase of long- term Treasury notes, to head off deflation by injecting more money into the banking system.

Vincent Reinhart, director of the Fed Board's Division of Monetary Affairs, said in a talk on May 29 that alternative policies could be used ''once the overnight rate has been driven to zero; as a way of driving the overnight rate to zero; or before the overnight rate hits zero.''

Many investors bet that meant the Fed would lower the overnight rate by half a percentage point on June 25. They sold after the central bank only lowered rates by a quarter point. More selling followed Fed Chairman Alan Greenspan's July 15 testimony to Congress that ''situations requiring special policy actions are most unlikely to arise.''

Market Disappointment

Many investors bet that meant the Fed would lower the overnight rate by half a percentage point on June 25. They sold after the central bank only lowered rates by a quarter point. More selling followed Fed Chairman Alan Greenspan's July 15 testimony to Congress that ''situations requiring special policy actions are most unlikely to arise.''

Yields on U.S. 10-year notes rose from 3.72 percent the day prior to Greenspan's testimony to 4.35 percent yesterday.

That, in turn, has pushed mortgage rates higher, threatening a pillar of the economy. Mortgage refinancings fell 2.4 percent in the week ended Aug. 1 to the lowest level since the first week in December, according to the Mortgage Bankers Association of America in Washington. The index is down 59.4 percent from a record high reached in the last week of May.

Greenspan and other Fed officials have lauded the refinancing boom as a source of support for the economy because consumers are paying less interest and extracting some their home equity. Economist now say higher rates may crimp fourth-quarter growth rates if investment spending and hiring don't offset the drop in refinancing.

''It is a race between mortgage rates and employment,'' said Ian Morris, chief U.S. economist at HSBC Securities USA. ''You have the negative impact of higher rates, but you don't have the positive effect of job growth hitting consumption yet. You might get a bounce of 5 percent in gross domestic product in the third quarter if inventories are being rebuilt, but as yet there is little evidence of that.''

Rates on Hold

Economists do expect the central bank to leave the overnight rate at 1 percent for at least the remainder of the year.

The Fed ''will only raise rates if inflation is a threat, and the economy is overheating,'' said Lara Rhame, an economist at Brown Brothers Harriman & Co. ''This is a recovery we are going to see materialize in fits and starts.''

Also today, the Fed left the primary credit discount rate on loans to banks from the Fed system unchanged at 2 percent.

On January 9, the Fed changed the cost of discount window loans. So-called primary credit, the loan rate for healthy banks, is now set at 1 percentage point above the fed funds rate, and secondary credit, a rate for distressed banks, trades at 1.5 percentage points over the overnight rate.

Last Updated: August 12, 2003 14:15 EDT