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Will Fed’s Surprise Rate Decision Bolster Economy, or Prolong Lending Malaise?

The threat of an imminent rise in interest and capitalization rates abated Tuesday, courtesy of the Federal Reserve’s plan to suppress short-term interest rates for the next two years. The measure helps to stabilize the economic outlook, but observers warn commercial real estate investors to be prepared in case capital costs rise despite the Fed’s efforts.

“The Federal Open Market Committee (FOMC) has provided some buoyancy for asset values,” says Sam Chandan, president and chief economist at New York-based Chandan Economics. “While the impact of easing is most readily observable in stock market volatility, low short- and long-term interest rates also relieve some of the upward pressure on cap rates and mortgage financing costs.”

The FOMC meets several times a year to take action aimed at keeping the economy on track, chiefly by manipulating the federal funds rate. Banks use the fed funds rate in overnight lending, and it is an important benchmark that influences short-, mid- and long-term interest rates.

Generally, the FOMC lowers the federal funds rate to stimulate borrowing and boost the economy. When growth becomes overheated, the committee raises its rate to dampen borrowing, slow the economy, and fight inflation.

An unexpected move

On Tuesday, the FOMC made an uncharacteristically long-term policy commitment by making clear that it expects to keep the federal funds rate between zero and 0.25% until mid-2013. But it was not a unanimous decision. The panel adopted its statement in a 7-3 vote. The three dissenters were hesitant to commit to such a lengthy period of low interest rates.

The dissenters would have preferred to word the Fed’s decision as “likely to warrant exceptionally low levels for the federal funds rate for an extended period,” the Fed stated in a news release.

Prior to the Fed’s announcement, Chandan and other forecasters were predicting a gradual increase in interest rates and borrowing costs that would force sellers to lower the price of real estate assets, weighing down all commercial property values in the process.

Those concerns were amplified Aug. 5, when rating agency Standard & Poor’s downgraded U.S. government debt from AAA to AA+, a move that may force benchmark Treasury yields up over time.

Yields on 10-year Treasuries plunged to an all-time low of 2.04% on Tuesday following the Fed’s announcement, however, before recovering to close at 2.19%.

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