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Why the Fed’s Interest Rate Decision To Keep Rates Low Came as a Surprise

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Bernanke Saving the Nation

Bernanke Saving the NationWhat Happened

Just last week the Federal Reserve voted to keep interest rates low until at least mid 2013, a bold statement to attempt to reassure consumers that rates are to stay low. Being that this is the first time that the Federal Reserve has pegged its rates to such a low rate, a bit of desperation within the Fed may be realized (see “Fed says it will Hold Rates” for more info).

The economy is certainly not growing at a comfortable rate. Our economy seems to be in the fast lane on the high way with the accelerator  set to cruise control at 28 miles per hour slowly changing the cruise control setting 1 MPH at a time.

Where’s the Surprise?

Cheap MoneyIn my previous two articles (Rates Stand to Increase and Indicators of Interest Rate Increases) on interest rates I had mentioned the possibility of an interest rate increase. Was I wrong? Not necessarily. I still strongly believe that mortgage rates stand to increase slightly. The reason is: the inflation rate. Even members of the Federal Reserve Board of Governors are worried about the inflation rate and hesitated in vowing to keep interest rates low as a result of inflation. In a rare showing of the possible disagreement throughout the Board, 3 out of 10 voters voted against this measure to peg interest rates at a low until mid 2013. Their primary concern (which is also likely the primary concern of those who voted for the measure nonetheless) is the inflation rate.

Current Inflation Rate June 2011

By briefly looking at the chart above it is immediately clear that inflation rates have been on a roller coaster ride over the last 4 years. However, fears are now mounting over an increasing inflation rate (from 1.5% at the end of 2010 to a steady 3.5%+ in mid 2011). In addition to the high unemployment rate, inflation increases prices at a faster rate than which wages can be increased. This makes buying daily goods more expensive. Countries typically combat inflation by making money (now cheap) more expensive (or raising interest rates).

Interest RateHow will the Fed’s decision affect Inflation?

It may very likely increase the rate of inflation to 4%. It may stay the same and hover at 3.5-3.6%, however this inflation rate is still undesirable for American Consumers. This high inflation rate could also lead to consumers withdrawing funds from low interest bearing savings account and investing them into something that may keep up with inflation, such as stocks or long term real estate (the best hedge against inflation).

How much do interest rates really affect buying?

It’s hard to say. A drop in mortgage rates will often create a spike refinances student loans and mortgages much greater than any potential spike in buyers. As a result, quality lenders become even more overworked. (See “What Rock Bottom Rates Mean for Consumer” for more info.)