After a year of aggressively slashing interest rates, Federal Reserve policymakers signaled that their rate-cutting days may soon be over — for now.
As expected, the Fed's Open Market Committee served up just a quarter-point cut Wednesday, leaving the benchmark for overnight loans between banks at just 2 percent — down from 5.25 percent when the rate slashing began last summer.
Some Fed watchers say we may see one more cut before the Fed pauses to see if its easy-money policy has the desired effect of boosting a sagging economy — without setting off another upward price spiral. But the comments attached to Wednesday's decision lead some to believe the Fed is headed for the sidelines.
"I think they're going to pause right now and that's the message we should be taking away," said former Fed Governor Susan Bies.
Fed Chairman Ben Bernanke and his colleagues may have little choice.
That's because soaring food and energy prices are beginning to spill over into the wider costs of other goods and services. And the quickest known antidote to higher inflation is to move interest rates back up again.
In explaining Wednesday's decision, the FOMC put less emphasis than in prior meetings on the risks of an economic downturn, and noted that " uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully."
Those developments include a continued surge in oil and gasoline prices. Oil recently came within a dime of $120 a barrel to set a record. Pump prices are up 55 cents a gallon in the past 10 weeks. Credit Suisse economist Jonathan Basile estimates that each penny at the pump costs American consumers roughly $1 billion in spending power.
So even as $150 billion in rebate checks begin showing up in taxpayer accounts, about a third of that stimulus money will already have been spent to pay for higher fuel costs.
Rate cuts have been the Fed’s main weapon against a slowdown, but each move usually takes at least six months to begin having the desired effect. While the economy has been flashing recession signals in the latest monthly data, Wednesday's report on growth in the fourth quarter of last year showed that the national Gross Domestic Product inched head at just 0.6 percent. Though very weak, the data have yet to confirm the economy is in outright recession. If, as many economists currently believe, the economy emerges from a shallow decline by year-end, the Fed is concerned that continued rate-cutting could make inflation worse when things begin to pick up again.
So far, the latest series of rate cuts seem to have had only mixed success with a more immediate goal — calming financial markets.
As the debt bombs created by lax mortgage lending standards began exploding last year — blowing big holes in the value of hedge funds and the balance sheets of financial services companies — the credit markets all but shut down. Nine months later, confidence is just beginning to return on the belief that the worst of the losses have already been reported.
The stock market, encouraged by a recent round of relatively strong corporate profits, has been moving higher in the past six weeks. Investors are betting that while the economy likely is in a recession it will begin expanding again by the end of the year. Many of the companies recently reporting strong quarterly results, especially those with overseas operations that have benefited from a weaker dollar, seem to share that view.
But the multitrillion-dollar capital market that supplies the essential raw material for the world's economy remains badly damaged. It may be that further cuts in interest rates won’t help much.
In addition to its aggressive rate cuts, the Fed has showered the markets with cash. In November, the central bank pumped $48 billion in temporary reserves into the banking system in its biggest combined daily injection of cash funds since the 9/11 attacks. In March the Fed said it was adding another $200 billion into the banking system.
The Bank of England and European Central Bank have made similar cash infusions to shore up the global financial system.
Despite these moves, commercial and investment banks are still nervous about lending to their counterparts because of concerns that one of them may be the next Bear Stearns, the Wall Street brokerage that was forced into a shotgun marriage with JP Morgan after it nearly collapsed under the weight of its bad loans.
Lower rates also have done little to revive the housing market, which remains mired in one of the most severe downturns in history. Mortgage issuers have responded to their former easy-money ways by dramatically tightening lending standards.
A weakening job market — some 300,000 jobs have been lost in four months — has taken some buyers out of the market and given others second thoughts. Gloomy consumer sentiment —which fell last month to the lowest levels in 26 years — continues to dampen home sales in what is typically the industry's strongest season. For a second year, it looks like spring will have come and gone without any signs of life for housing market.
The Fed has another strong reason to signal that it wants to take a breather from cutting rates — it may soon have to start raising them again. Lower rates and easy money help drive inflation — at the very moment the Fed is also hoping to contain it.
The gamble is that a slowing economy will reduce demand, taking pressure off prices. But the forces driving up oil prices include strong demand from a still-growing global economy and tight supplies brought by limits in surplus production. The Fed is powerless to reverse those forces.
And the full impact of the recent run-up in food and energy prices may take months to work through the system. The longer the Fed waits before tightening credit and raising rates, the bigger the risk that inflation will become more deeply embedded in the U.S. economy —and more difficult to fight.