Fed holds rates steady in close call; strongly signals Dec. hike

WASHINGTON--A divided Federal Reserve found a new reason Wednesday to hold off on an interest rate hike: a stagnant unemployment rate.

Fed Chair Janet Yellen told reporters that despite solid job growth this year, the unemployment rate has been stuck at 4.9% because discouraged workers on the sidelines have been drawn into an improving labor market. She called that a positive development policymakers want to encourage by keeping rates low longer.

"The economy has a bit more running room than might have been previously thought," Yellen said at a news conference.  At the same time, she said, "We don't want the economy to overheat," adding that the case for a rate increase "has strengthened" and a move is expected later this year.

But Barclays economist Rob Martin suggested the biggest reason the Fed stood pat again was unusual discord among policymakers who are trying to balance a slowly-growing economy with the less tangible risk of excessive inflation down the road. Three of the 10 voting policymakers dissented, preferring to hike rates Wednesday, including Boston Fed chief Eric Rosengren, who typically favors keeping rates low to stimulate the economy. All told, three officials forecast no rate increase this year, 10 anticipate one bump and four are looking for two moves.

Martin says Yellen is hoping better economic data will allow her to forge consensus for a rate increase in a few months.

Fed statement of Sept. 21, 2016

The Fed strongly signaled that action late this year is likely.  In a statement after a two-day meeting, the Fed said, “Near-term risks to the economic outlook appear roughly balanced,” its first such positive assessment this year. It added that "economic activity has picked up" and "job gains have been solid."

"They were trying to tee up markets for a rate hike before the end of the year," Scott Anderson, chief economist of Bank of the West, said of the Fed's multiple hints.

In the end, though, the Fed kept its benchmark rate at a historically low 0.4%, where it has stood since officials raised it in December for the first time in nearly a decade.

The Fed reiterated inflation continues to run below its annual 2% target, giving officials time to act. "We're not seeing evidence that the economy is overheating," Yellen said.

Earlier this year, Fed officials cited China’s slowdown, weak U.S. job growth, the United Kingdom’s Brexit vote and financial market turbulence as obstacles that stayed their hand. Those concerns largely have eased, but Yellen on Wednesday pointed to weak productivity gains that are likely to temper economic growth over the longer-term.

And so for the third straight meeting, the Fed lowered its forecast for rate hikes over the next few years as policymakers have become warier about the economy's growth potential.. Their latest median estimate would bring the benchmark rate to 0.6% at the end of 2016, down from their previous forecast of 0.9%. They also expect fewer rate hikes in coming years, projecting the key rate will be 1.1% at the end of 2017 and 1.9% at the end of 2018, down from their prior estimates of 1.6% and 2.4%, respectively.

Officials also modestly downgraded their economic outlook. They expect growth of 1.8% this year, below their previous 2% forecast. Their estimate of 2% economic growth in 2017 and 2018 was unchanged but they trimmed their longer run forecast to 1.8% from 2%.

They now expect the 4.9% unemployment rate to dip to 4.8% by year-end, slightly higher than their June forecast of 4.7%.

Low inflation continues to be a major roadblock to faster hikes.The officials expect a core measure of annual inflation that strips out volatile food and energy items to meet their previous prediction of 1.7% by the end of the year, but they slightly revised down their estimate for 2017 to 1.8% from 1.9%.

The economy has been held back by tepid growth and inflation since the Great Recession ended in 2009. "We're struggling with a difficult set of issues," Yellen said. "What is the new normal in this economy?"

Fed holds fire on rates, avoids stock market shock