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Traders work in the Eurodollar Futures Pit at the Chicago Mercantile Exchange, just after the interest-rate news was announced. Stocks slipped Tuesday amid investor fears that the Fed's move signaled a weakening of the U.S. economy.
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For now, the Federal Reserve is holding the line on a key interest rate — its first pause in an unbroken series of rate hikes that began more than two years ago to help curb inflation. The benchmark federal funds rate will remain at 5.25 percent. That rate helps determine what consumers and businesses pay for various types of loans, and thus affects spending and economic growth.
The Fed's decision comes amid weaker-than-expected job growth for July, and a GDP that slowed to 2.5 percent in the second quarter from its blistering 5.6 percent first-quarter pace. Further clouding the economic outlook: sluggish productivity and a housing market that's quickly gone from hot to not.
What's it all mean for the U.S. economy? Gus Faucher, a senior economist with Moody's Economy.com, helps explain.
Q: Why did the Fed take a break from rate hikes?
They've been raising rates for more than two years now. The Fed has definitely seen the impacts of those rate hikes playing out — in the slowing of the housing market and so forth. They are concerned about what's going to happen with economic growth. They're concerned that, if they continue to raise rates, that will choke off growth, too. Right now they are going to wait to see how things turn out.
Q: So is the Fed now more worried about a slowing economy than inflation?
The Fed maintained a "tightening bias," which indicates that they are still concerned about inflation more than slower growth. [A "tightening bias" means the Fed remains on the lookout for inflation and could raise rates again in response.] But the Fed wants to see how the interest-rate increases of the past two years have played out, and they think inflation is going to slow because of the slowing in overall economic growth that we've already seen and continue to see.
Q: What indicators suggest we are heading for inflation?
So-called core consumer prices, which exclude food and energy prices, have increased at a higher-than-predicted rate for the past four months. In particular, we've seen a pickup in things such as medical services, education, recreation, housing, rent, restaurant meals, hotels, vehicle costs and that kind of stuff.
Q: What does a rate pause mean for consumers?
It means that they are less likely to see short-term interest rates move higher on products such as auto loans, credit cards and adjustable-rate mortgages. Rates on those types of products have been moving higher — and that's what the Fed wanted to do. The Fed was concerned particularly with the growth in the housing market. Because of past rate hikes, it has now become more expensive to buy a house with an adjustable-rate mortgage, which has helped slow housing down.
Q: Most experts now agree that the housing market has indeed slowed across the country. Will the pause in rate hikes help speed it back up?
The housing market is going to continue to slow. Monetary policy works with a lag. Housing affordability has moved much lower, because of both the rapid increases in prices and higher-interest rates. We don't expect affordability to get much better any time soon. Therefore, the housing market will continue to soften. And that's where a lot of the growth in the U.S. economy has been coming from.
Q: Is housing now too slow?
Well, certainly, there is concern about a big housing correction — not just flat prices but falling prices. There's particular concern in areas that saw the biggest run-up in prices — California, Florida and parts of the Northeast. It's definitely the case that sales are slowing. The National Association of Home Builders index has moved into contraction territory. Residential construction employment has declined a bit. From the Fed's perspective, that's a good thing.
Q: Is the Fed done with rate hikes for now?
We think the Fed is going to hold things steady through the end of this year and then start to reduce the federal funds rate sometime in 2007. For this cycle, the rate is as high as it will go. We think that growth should slow enough that it will help reduce inflationary prices.
Q: Any chance that consumers will see lower interest rates?
Not anytime soon. In terms of short term rates, we don't expect the Fed to relax those until early next year.
Q: Some economists are warning that the U.S. may be headed toward recession. Is that a growing concern?
We don't think the economy is going into recession. That's one reason the Fed stopped its rate hikes, to make sure the U.S. economy doesn't go into recession. Growth is definitely slowing, and the economy will be expanding at slightly below its potential, which is defined as how quickly it can grow over the long run without sparking inflation. But fundamentals remain strong, business investment is strong, and employers continue to keep hiring.
Q: What economic indicators have economists nervous?
We're watching what goes on with the housing market. Are we going to see a slowing or a big correction?
We're also watching what happens to business investment. Right now, profit margins are near record highs. Are businesses going to get concerned about what's going on in the Middle East and energy prices and pull back on investment? That could spell real problems for the U.S. economy.
And economic growth is also tied to what's going on with the job market. Even though interest rates have moved higher, which has slowed growth on the consumer side, on the other hand, the job market has improved and helped increase wages.