Fed Keeps Interest Rates the Same
For the fifth straight time, the Federal Reserve Board voted today to hold interest rates steady. This leaves the federal funds rate, which banks charge one another on overnight loans, at 5.25 percent.
In announcing its decision, the central bank indicated that inflation pressures are likely to ease in the coming months, which means the Fed is probably done raising short-term interest rates. At the same time, the Fed noted that the economy is growing sufficiently on its own, so a rate cut isn't necessary either.
Indeed, just this morning, the Commerce Department reported that the economy actually accelerated significantly at the end of last year. After growing at an annual rate of 2 percent in the third quarter of 2006, gross domestic product–the broadest measure of the U.S. economy–expanded at an annual pace of 3.5 percent in the final three months of the year.
"The economy has clearly caught its second wind in the fourth quarter," says Bernard Baumohl, managing director of the Economic Outlook Group. "After six months of below-trend growth, the combination of higher real wages, low unemployment, and the drop in energy prices ignited the economy's engines once again."
The Fed's monetary policy committee seemed to agree. In its statement following today's decision, the central bank noted that "recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market."
That statement, along with this morning's GDP report, helped push stock prices higher Wednesday, as the Dow Jones industrial average was up more than 100 points in late-afternoon trading.
In general, investors now believe that a rate cut–not a rate hike–is likely to be the Fed's next move. In fact, the Fed all but said that inflation has become less of a threat.
But while investors had assumed late last year that the Fed might start to trim rates by this spring, many now believe that the central bank will leave rates where they are for the full year, especially given this morning's GDP report. In other words, unless the economy and labor markets start to falter significantly, the Fed may not start cutting rates until 2008.
Why does it matter if the Fed starts to cut in 2007 or 2008, so long as the next move is a reduction in interest rates?
Well, if you're a long-term, buy-and-hold investor who never attempts to "time" the stock market, then it probably won't matter to you over the long run. But many investors make tactical adjustments to their portfolios based on factors such as the economy's health or geopolitical concerns. In that case, the timing of the Fed's rate cut matters a great deal.
That's because stock market behavior tends to change dramatically soon after the Fed begins to trim rates. History has shown that the types of stocks that thrive in the period before a Fed rate cut are altogether different than those that do well shortly after the Fed starts easing monetary policy.
Sam Stovall, chief investment strategist for Standard & Poor's, studied periods in recent history in which the Fed had finished raising interest rates but had not yet started to lower them. He refers to these times as "plateau periods."
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