Fed Nudges Up Key Rate to Ward Off Inflation
The Federal Reserve nudged up its key interest rate Tuesday, suggesting that the central bank thinks the American economy needs a little--but only a very little--extra protection against inflation.
The decision was widely anticipated and appears to put the Fed firmly in the camp of those who believe the economy can go right on growing even with wages rising and qualified workers increasingly hard to find.
The Fed coupled its quarter-point hike in the federal funds rate with a decision to maintain its wait-and-see attitude toward future increases. It issued a bullish statement saying its actions “should markedly diminish the risk of rising inflation going forward.”
“They think the run of growth without inflation we’ve had is more than a lucky break,” said Peter H. Kretzmer, a senior economist with Bank of America in New York. “They hope that by tweaking these rates they can extend the run for some time to come.”
The central bank increased the federal funds rate, the rate at which banks make short-term loans to each other, from 5% to 5.25%.
In response, three major banks--Bank One, First Union and Wells Fargo--raised their prime lending rate by a quarter-point to 8.25% immediately after the Fed acted.
While the Fed’s increase was intended to slow economic activity by raising the borrowing costs of everybody from corporate executives to home buyers, analysts said much of the adjustment has already occurred.
Rates on a 30-year mortgage, for example, have risen more than a percentage point so far this year to about 8%, knocking new home loan applications off their record highs, according to Freddie Mac, the quasi-public mortgage corporation.
“This is not going to make a big difference,” said Peter D’Antonio, an economist with New York-based Salomon Smith Barney. Fed policymakers “are trying not to squash the economy, just temper it,” he said.
Financial market reaction was mixed after the Dow had surged 199 points Monday to a record, anticipating the Fed. The Dow finished the day off 16.46 points, or 0.1%, at 11,283.30.
Bond yields continued to slide from what had been 22-month highs as recently as two weeks ago. Tuesday’s action was the latest loop in the roller-coaster ride that began earlier this year when Fed Chairman Alan Greenspan said that the nation’s labor markets were growing so tight they could send wages and then prices spiraling upward. He warned that the central bank was ready to prevent that by raising interest rates to slow the economy.
In fact, the Fed did raise the federal funds rate a quarter-point on June 30. But it coupled the increase with a decision to remove its tilt in favor of further rate hikes, a move that was widely taken as signaling that no further increases were on the way.
What’s most remarkable about the Fed’s latest decision is its modesty in the face of some of the very trends that Greenspan and others had said would provoke decisive action. The most striking are those involving wages and benefits.
In recent weeks, the government has said that its broadest measure of labor costs, the employment cost index, climbed 1.1% in the three months from April through June, triple its rate from January through March. Average hourly earnings rose 0.5% in July, their biggest monthly jump since the start of the year.
Analysts said that the Fed took only restrained action because there is little evidence that price increases are coming on the heels of the wage hikes. And price increases are the Fed’s biggest worry.
“The latest inflation data is utterly fantastic,” said Brian S. Wesbury, chief economist with Griffin, Kubik, Stephens & Thompson, a Chicago investment bank. Consumer goods rose a mere 0.3% in July.
Beyond such immediate evidence, the Fed also appears to be banking on a continuation of the yet-to-be-understood forces that have let the nation enjoy longer, stronger growth with lower unemployment and inflation than most economists had believed possible. The current expansion will break the record for the longest in history if it lasts until the early months of next year.
“They’re making a mega-bet that this really is a new economy, and that inflation is not a problem,” said Stephen S. Roach, chief economist with Morgan Stanley in New York. “Let’s hope they’re right.”
The central bank’s move still leaves the federal funds rate a quarter-point below its 5.5% level of a year ago, before the central bank slashed rates three times beginning in September. That was to cope with a financial markets panic in the wake of Russia’s debt default and a string of currency crises that reached as close to home as Brazil.
Analysts were divided over whether the central bank would take back the final quarter-point by raising rates again later this year. A Reuters poll of 30 Treasury bond dealers found that 25 believed that the central bank had finished its work for the year. However, James A. Bianco, a bond market strategist in Barrington, Ill., said that investors in the federal funds futures markets were betting on a further increase.
Besides raising the federal funds rate, the central bank also raised the discount rate, which the Fed itself charges when lending to banks, from 4.5% to 4.75%. Analysts said that move had little economic significance because banks rarely borrow directly from the Fed for fear of appearing financially weak. The hike, analysts said, was intended to maintain the historical percentage-point spread between the discount rate and the federal funds rate.
* COST OF MONEY: Borrowers will pay higher interest as banks react to action. C1
* MARKET’S FOCUS: Wall Street will now turn to corporate profits, the dollar. C4
(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
Why the Fed Acted Again
Indicators released since the Federal Reserve last raised rates, on June 30, showed enough remaining economic muscle to prompt Tuesday’s hike:
