Fed Signals Return to Growth Alone Won’t Warrant Rate Increase

By Scott Lanman

Nov. 5 (Bloomberg) -- Federal Reserve officials signaled a return to economic growth alone won’t warrant higher interest rates, saying an increase will instead depend on when the labor market and inflation pick up.

The Fed’s rate-setting Open Market Committee yesterday restated its pledge to keep rates “exceptionally low” for an “extended period.” The panel added for the first time that its commitment depends on “low rates of resource utilization, subdued inflation trends and stable inflation expectations.”

The comments prompted traders to reduce bets for an increase in borrowing costs in the first half of 2010, given that policy makers are focused on reducing unemployment that’s forecast to rise above 10 percent. The dollar weakened yesterday and short-term Treasury yields fell.

“There are still many downside risks to the recovery,” said Chris Rupkey, chief financial economist at Bank of Tokyo- Mitsubishi UFJ Ltd. in New York. “The Fed looks to be on hold for longer than I thought,” possibly beyond the second quarter, he said.

Policy makers, acting the week after a report showed the U.S. economy expanded in the third quarter for the first time in more than a year, left their target for the overnight interbank lending rate unchanged at a range of zero to 0.25 percent. The vote of 10 officials was unanimous.

The conditions “put some meat on the bones” of the Fed’s rate stance, said John Silvia, chief economist at Wells Fargo Securities LLC in Charlotte, North Carolina.

‘Not Unlimited’

“The Fed is simply trying to set up conditions or parameters for the continuation of the current easy policy, so that it’s not unlimited with no boundaries,” said Silvia, who previously worked as a senior economist in Congress. Silvia didn’t change his forecast for the Fed to raise interest rates after July 2010.

The dollar weakened after the decision, falling to $1.4861 against the euro from $1.4724 on Nov. 3, the biggest drop since Sept. 8. The yield on two-year Treasuries fell 2 basis points to 0.90 percent from 0.92 percent, while yields on 10-year securities rose 6 basis points to 3.53 percent from 3.47 percent. A basis point is 0.01 percentage point.

U.S. employers probably reduced payrolls by 175,000 in October, according to the median forecast in a Bloomberg News survey of 84 economists ahead of Labor Department report tomorrow. The unemployment rate probably rose to 9.9 percent from 9.8 percent, based on the median estimate of 81 analysts.

Prices Fall

Consumer prices have fallen on an annual basis for the past seven months in the longest such decline since 1955. The consumer-price index fell 1.3 percent in the 12 months to September. Excluding food and energy, prices rose at a 1.5 percent annual rate.

While some measures of inflation expectations have been rising, the Fed said longer-term expectations are “stable” and reiterated that price increases “will remain subdued for some time.”

The ebb of the global crisis that caused more than $1.6 trillion in credit losses and writedowns has already helped spur central banks from Australia to Norway to start increasing borrowing costs. Yesterday’s unanimous statement indicates the Fed isn’t yet ready to follow some of its counterparts abroad.

“We are nowhere near there,” Michael Holland, chairman of New York-based Holland & Co., which oversees more than $4 billion in assets, said on Bloomberg Television. “We don’t have anything approaching the position where they can start unwinding.”

Through First Quarter

The Fed completed its $300 billion program of purchasing Treasuries last month. Yesterday’s statement said the central bank will purchase a total of $1.25 trillion of agency mortgage- backed securities and about $175 billion of agency debt through the first quarter of next year.

Previously, the Fed said it would buy as much as $200 billion of debt issued by Fannie Mae and Freddie Mac, the government-supported mortgage-finance companies, and government- chartered Federal Home Loan Banks. The central bank said the change is “consistent with the recent path of purchases and reflects the limited availability” of the notes.

“It’s a relatively small change,” said Michael Hanson, senior economist at Bank of America-Merrill Lynch in New York and a former Fed economist. “They don’t want to do anything that’s going to really knock markets off kilter.”

The bigger change was adding the 13 words that clarified the “extended period” pledge on interest rates, economists said. The shift, while prompting investors to lengthen their prediction for a tightening, gives the Fed less leeway to avoid rate increases when labor and inflation indicators start rising.

Adding the three conditions “gives investors a framework when rate hikes are likely to come and forces discipline on the Fed,” said Chris Low, chief economist at FTN Financial in New York. “When those conditions change, it almost forces them to follow through.”

To contact the reporters on this story: Vivien Lou Chen in San Francisco at vchen1@bloomberg.netScott Lanman in Washington at slanman@bloomberg.net.