Fed Leaves Rates Unchanged; Historic Lows Expected for 'Extended Period'

FOMC gives nod to deflation risk; will reinvest mortgage bond payments in long-term Treasuries

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The Federal Reserve's policymakers agreed to keep interest rates at historic lows on Tuesday, August 10, as the nation's economy continues to struggle against deflation threats, lackluster growth, and the possibility of a double-dip recession.

The Federal Open Market Committee (FOMC) voted to maintain the target range for the federal funds rate at zero to 0.25%, saying in a statement that it "continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

Economists had widely expected the Fed's policymakers to keep interest rates where they are. The FOMC, which holds eight regularly scheduled meetings during the year, has kept rates at historic lows near zero since December 2008.

Doug Roberts, chief investment strategist for ChannelCapitalResearch.com, Shrewsbury, New Jersey, said the most striking part of the FOMC statement was the Fed's plan to inject liquidity into the economy by using repayments on agency debts such as mortgage-backed securities to buy long-term Treasuries in the 5- to 20-year range.

With short-term rates so low, Roberts said, this is another policy tool in the Fed's arsenal.

"Whether it has any long-term effect, that's open to debate," he said. "Japan did the same thing [in the 1990s], and aside from brief spurts, it really hasn't done that much for the Japanese economy. What people are hoping is that we'll have more success than Japan did."

Specifically, the FOMC stated that to help support the economic recovery in a context of price stability, "the committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities."

While the FOMC didn't use the term "deflation" outright, it did acknowledge the economy's potential to slip into a deflationary spiral of lower wages, prices, and consumer demand.

"Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time," the FOMC said in its statement.

The committee also acknowledged that since it met in June, the pace of recovery in output and employment has slowed.

The FOMC said: "Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls. Housing starts remain at a depressed level. Bank lending has continued to contract. Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated."

The decision came on the heels of the Labor Department jobs report for July, released August 6, which showed the U.S. unemployment rate holding flat at 9.5% in June and July and the number of unemployed persons unchanged this summer, at 14.6 million.

Voting for the FOMC monetary policy action were Fed Chairman Ben Bernanke, Vice Chairman William Dudley, James Bullard, Elizabeth Duke, Donald Kohn, Sandra Pianalto, Eric Rosengren, Daniel Tarullo, and Kevin Warsh.

Voting against the action was Thomas Hoenig, "who judges that the economy is recovering modestly, as projected," according to the FOMC statement. Hoenig, who is president of the Federal Reserve Bank of Kansas City, believed that continuing to express the expectation of exceptionally low levels of the fed funds rate for an extended period was no longer warranted "and limits the committee's ability to adjust policy when needed."

Read a story about the FOMC's June 23 decision to hold rates at historic lows from the archives of InvestmentAdvisor.com.

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