Why the Federal Reserve Is Reluctant to Raise Interest Rates

The Fed could be "playing with fire," according to one economist.

— -- When the Federal Reserve announced this afternoon that it was going to take the cautious step and leave interest rates unchanged for the time being, it also said that “near-term risks to the economic outlook have diminished.”

So what concerns might the Fed have? And why are they being so cautious?

According to Barclay’s Chief U.S. Economist, Michael Gapen, it goes back to the exceptional nature of the recent Great Recession.

“There are recessions and then there are recessions,” he told ABC News, noting that the recession and financial crisis of the late 2000s was much more intense than typical, cyclical recessions.

Gapen said, “The Fed believes that the economy will need more monetary support than it normally would, which means that interest rate rises start later, proceed slower and end at a lower level.”

And while many parts of the economy have bounced back, Gapen said that Federal Reserve officials will be paying special attention to the labor market.

“I really think right now it’s about labor markets, so employment growth still has to be fairly solid,” he said. “Labor markets are the most clear, consistent signal about expansions and contractions more than any other variable,” when it comes to measuring the health of an economy.

So what could make the Federal Reserve feel confident enough to raise rates?

The answer, experts say, is a higher inflation rate.

“If labor markets keep improving, eventually you would get some wage growth and therefore it would support inflation,” Gapen said.

And since the Federal Reserve is charged with controlling inflation, any significant increase in that could spur them to also increase interest rates.

Robert Johnson, Director of Economic Analysis at Morningstar, told ABC News that while overall inflation sits at about 1 percent right now, certain segments are much higher -- most notably, core inflation (which excludes food and energy) is about 2 percent. Johnson predicted that overall inflation could also rise to 2 percent by December.

But the Fed will be cautious to act because changes in the interest rate have effects from Wall Street to Main Street.

One notable way that the rate affects everyday life is its influence on mortgage rates.

The housing market has been acting as a “key driver of the recovery” from the recession, Johnson said, and it “has been exceptionally sensitive to mortgage rates over the past few years.”

“Even the small hike in December slowed housing sales in January and February,” he said. “Not until the Fed put off another rate hike this spring, causing mortgage rates to fall again, did the housing market start acting better.”

Another consideration is the interest rates’ potential affect on the dollar’s value and foreign exports. If the U.S. raises rates, while other countries are slashing theirs, the dollar could become very strong, which would in turn harm U.S. exports.

So, while the Fed appears to be taking a cautious approach in leaving interest rates unchanged, Johnson said they are “playing with fire.”

“If some geo-political event were to send oil soaring or we had another crop failure, inflation could get out of hand very quickly,” he said. “With more retiring baby boomers, low unemployment rates and potential labor shortages pushing wages higher, the underlying inflation rate is moving higher and may prove difficult to control.”