Federal Reserve Raises Key Interest Rate to 4%
The Federal Reserve on Tuesday offered no letup in its fight against inflation, raising its benchmark short-term interest rate another quarter-point for the 12th consecutive time while stating that more hikes are coming.
The central bank’s boost in its federal funds rate to 4%, the highest since June 2001 and up from 1% in June 2004, continued the debate about whether the Fed might be overestimating inflation threats and raising rates too much, risking a possible economic slowdown. Some experts contend that the Fed should stop soon, noting that energy prices have been falling and inflation outside of energy has been relatively tame.
But the Fed on Tuesday signaled that it would have none of that time-to-quit talk, clearly suggesting that rising prices remain public enemy No. 1. Although inflation outside of energy and food “has been relatively low in recent months and longer-term inflation expectations remain contained,” the Fed said, “the cumulative rise in energy and other costs [has] the potential to add to inflation pressures.”
Thus, the central bank reiterated that it would continue to tighten credit at a “measured” pace -- Fed-speak for more quarter-point rate increases.
The Fed also showed confidence in the economy’s ability to rebound from hurricanes Katrina and Rita.
“Elevated energy prices and hurricane-related disruptions in economic activity have temporarily depressed output and employment,” the Fed said. But relatively low interest rates and robust productivity growth are “providing ongoing support to economic activity that will probably be augmented by planned rebuilding in the hurricaneaffected areas.”
The Fed “offered not so much as a hint of a hint yesterday that the end is in sight for the tightening program,” said Ian Shepherdson, chief U.S. economist for High Frequency Economics in Valhalla, N.Y.
If anything, he said, the Fed suggested that it would continue to raise rates even if economic growth slowed in the fourth quarter. The Fed also signaled that recent energy price declines would not give it “an excuse to stop raising rates,” Shepherdson said.
Tuesday’s decision was unanimous, unlike the last increase Sept. 20, when Fed Gov. Mark W. Olson dissented on grounds that the central bank should take more time to assess Katrina’s effects.
Stock investors, who have been hoping for any signal from the Fed that it may soon halt raising rates, were subdued. Major stock indexes fell Tuesday, though they were near where they stood when the Fed decision was announced. Bond yields rose slightly.
The increase in the federal funds rate, which banks charge each other for overnight loans, will lead to higher borrowing costs for consumers and businesses. Many banks Tuesday immediately raised their prime lending rate by a quarter-point to 7%, which will in turn boost charges on some home equity loans, variable-rate credit cards and other borrowings whose rates are pegged to the prime. The Fed’s rate hike might indirectly add to pressures recently pushing up mortgage rates.
Consumers, however, should eventually see higher returns on certificates of deposit and other savings instruments.
Economists see the Fed initiating two more quarter-point rate increases, taking its benchmark rate to 4.5%, by the time Ben S. Bernanke is expected to take over as Fed chairman Feb. 1. Bernanke, a former Fed governor and now President Bush’s chief economic advisor, was nominated for the post a week ago by Bush and is expected to win confirmation easily. Current Chairman Alan Greenspan will preside over his last meeting Jan. 31 before his term expires.
The question now is whether a Bernanke-led Open Market Committee will continue to raise rates, perhaps to prove his inflation-fighting mettle. Some analysts expect him to oversee an increase to 4.75% at his first policy meeting March 28.
Many experts say the Fed wants to ensure that consumers and businesses don’t begin to expect higher inflation. Such expectations can become selffulfilling, as was the case in the 1970s. If workers expect higher prices, they will demand higher wages. And businesses expecting higher costs will pass them along to customers through higher prices.
Recent consumer sentiment surveys have shown a worrisome increase in inflation expectations, largely because of high energy prices. But wage increases still appear to be subdued, not keeping pace with inflation.
Many analysts expect the economy to slow somewhat from its surprisingly strong 3.8% annual growth pace in the second quarter, but recent economic data give mixed signals. Business spending appears strong, but once-sizzling home price increases are slowing and consumers are moderating their spending amid higher energy bills.
“This sets the stage for a modest [consumer] expenditure growth slowdown in the fourth quarter, providing support for the Federal Reserve’s very gradual approach to adjusting rates,” said Brian Bethune, U.S. economist for Global Insight, an economic research firm in Lexington, Mass.
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Fed Statement
Here is the Federal Reserve’s statement Tuesday on interest rates:
The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points [0.25 percentage point] to 4%.
Elevated energy prices and hurricane-related disruptions in economic activity have temporarily depressed output and employment. However, monetary policy accommodation, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity that will likely be augmented by planned rebuilding in the hurricane-affected areas. The cumulative rise in energy and other costs [has] the potential to add to inflation pressures; however, core inflation has been relatively low in recent months and longer-term inflation expectations remain contained.
The committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.
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Outlook for other interest rates
Here is a look at where some key interest rates stand and the outlook following the Federal Reserve’s latest boost in its benchmark rate to 4% from 3.75%.
Item: Prime lending rate
Current rate: 7%
Outlook: A number of major banks raised the prime a quarter point Tuesday, matching the Federal Reserve’s rate increase. The prime, a benchmark for many consumer loans--such as home equity credit lines--usually changes immediately with Fed shifts. Next Fed meeting: Dec. 13.
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Item: Money market fund yield (seven-day average)
Current rate: 3.21%
Outlook: Money fund yields recently topped the 3% level for the first time in four years. The funds’ yields usually track Fed rate changes, with a lag of six to eight weeks.
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Item: One-year CD yield (U.S. average)
Current rate: 3.2%
Outlook: Banks have been bumping up certificate of deposit rates in recent weeks, and CD rates should continue to edge higher with the Fed’s latest rate hike.
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Item: 10-year Treasury note yield
Current rate: 4.56%
Outlook: Bond rates are set by the marketplace, not by the Fed, and take their cue from the economy’s strength and the outlook for inflation. The 10-year T-note yield has risen since the summer as investors have anticipated stronger inflation and more rate hikes by the Fed to combat it.
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Item: 30-year mortgage rate (Freddie Mac average)
Current rate: 6.15%
Outlook: Mortgage rates typically follow long-term bond yields. The average 30-year home loan rate is at its highest since July 2004.
Graphics reporting by JOSH FRIEDMAN
Sources: Informa Research Services; Inmoney.Net; Bloomberg News
