THE BASIS POINT

FOMC Keeps Fed Funds At 2%, Warns On Inflation (Full Statement & Analysis)

Following their meeting today, the Federal Open Market Committee kept the bank-to-bank Fed Funds Rate at 2% and the Fed-to-bank Discount Rate at 2.25%, and said that “The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.” This is following their June 25 statement where they said “uncertainty about the inflation outlook remains high,” and “upside risks to inflation and inflation expectations have increased.” These past two statements are in conflict, but today’s statement matches the April 30 statement, in which they implied weak economic activity and inflationary threats (in energy and commodity prices) may offset each other.

Interest rates were slightly higher on the news, since markets are still digesting the jarring PCE inflation data from yesterday, which puts year-over-year Core Personal Consumption Expenditures up 2.3%, which is outside of the Fed’s target zone of 1-2% inflation (“Core” excludes food and energy, the “Overall” number is 4.1%). Core PCE of 2.3% relative to a 2% Fed Funds Rate means inflation-adjusted rates are -0.3%. If you do an inflation-adjusted Fed Funds Rate with Overall PCE of 4.1%, real rates are -2.1%. Inflation definitely has to moderate if the Fed is to keep rates as low as they are.

Despite being an inflation fighting crusader, Philadelphia Fed president and FOMC member Charles Plosser voted to hold just like he did last month (he voted against the cut in April). The only FOMC member who voted to increase instead of hold was FOMC member and Dallas Fed President Richard Fisher because he believes that inflation is more of a threat than economic weakness.

For a briefing on why rate cuts can cause even more inflation, see this story.

From September 2007 to April 2008, the Fed cut the bank-to-bank Fed Funds Rate 3.25% (from 5.25% to 2.0%), and cut the Fed-to-bank Discount Rate 4.0% (from 6.25% to 2.25%). This is the second pause since that cut cycle. The full August 5 FOMC statement is below.

The Discount Rate means that commercial banks can get 28 day loans from the Fed at 2.25%, which makes it a viable way to access funds amidst the continuing credit crunch — it’s also important to note, that until further notice, investment banks can also access the Discount Window in addition to commercial banks. And instead of being limited to 28 day loans, both entities can get loans up to six months if they meet certain underwriting requirements. These measures have been implemented by the Fed in recent months to help credit markets. The hold on Fed Funds Rates means Home Equity Line of Credit 2nd mortgages will remain at 5% plus margin — all HELOCs are the Prime Rate plus a base rate (which is called a margin), and Prime is Fed Funds Rate + 3%.

FULL FOMC STATEMENT AUGUST 5, 2008
The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Economic activity expanded in the second quarter, partly reflecting growth in consumer spending and exports. However, labor markets have softened further and financial markets remain under considerable stress. Tight credit conditions, the ongoing housing contraction, and elevated energy prices are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations have been elevated. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Voting against was Richard W. Fisher, who preferred an increase in the target for the federal funds rate at this meeting.