Fed Raises Rates Modestly, Signals Neutral Stance
The Federal Reserve raised a key interest rate a modest quarter of a point to 5% on Wednesday to keep the U.S. economy from overheating but unexpectedly signaled that it doesn’t plan further rate hikes.
The Fed’s subtle but important shift was greeted with exuberance on Wall Street, which had braced for a series of interest rate increases intended to slow economic growth.
But its message--that the danger of excessive growth is so small that further rate hikes won’t be necessary--struck some analysts as being at odds with policymakers’ highly publicized concerns about the threat of renewed inflationary pressures.
The Dow Jones industrial average shot up 155.45 points, or 1.4%, to close at 10,970.80. The technology-heavy Nasdaq composite index sailed into record territory, jumping 44.01 points, or 1.7%, to 2,686.12. The price of the benchmark 30-year Treasury bond also rose, driving its yield, which moves in the opposite direction, below 6%.
But the Fed’s action in lifting the federal funds rate, which it sets for banks to make short-term loans to one another, revealed considerable uncertainty within the Fed itself. Does the Fed believe the economy is running near its limits and is in danger of setting off a damaging price spiral? Or does it think the eight-year expansion still has steady growth left in it?
“This is a Fed that doesn’t see anything seriously wrong with the economy right now, but is not sure why,” said Donald Ratajczak, economic forecasting director at Georgia State University in Atlanta. “It’s clearly bewildered about how we have such low unemployment without inflation.”
The Fed’s policymaking body, the Federal Open Market Committee, acknowledged as much in removing the bias it adopted in May in favor of rate hikes.
“Owing to the uncertain resolution of the balance of conflicting forces in the economy . . . the FOMC has chosen to adopt a directive that includes no predilection about near-term policy action,” said the statement announcing the central bank’s action.
The central bank’s task of figuring out where the economy is headed was complicated further by Wednesday’s news that a key gauge of future economic activity rose 0.3% in May, reversing course after a 0.1% decline in April and contradicting other recent figures that suggest growth may be slowing.
The modest size of Wednesday’s increase in the federal funds rate ensures that it will have only modest impact on the market interest rates that matter to most Americans--those on mortgages, car loans, credit cards and the like. Indeed, analysts said, if financial markets take seriously the central bank’s tilt away from further increases in the federal funds rate, some market rates could actually fall, not rise.
“Nobody believes a quarter-point will really take the U.S. economy down or do much about the inflation the Fed says it’s worried about,” said Allan Sinai, president and chief economist of Primark Decision Economics Inc. in New York.
The Fed’s action could also undercut its own warnings about the stock market. If investors interpret it as signaling that the central bank believes the economy still has a lot of noninflationary growth left in it, they are likely to send stock prices higher even though Fed policymakers have warned that the market may be reaching the proportions of a financial bubble.
The most immediate effect of the hike seems likely to be a rising edginess as investors, economists and policymakers scan the landscape for changes that might jolt the central bank into more decisive action.
“People are going to be looking at every single number” for new signs of inflation or of further pickup in the economy, said Lynn Reaser, chief economist with Bank of America Private Bank in Jacksonville, Fla.
The rate increase was the first since a quarter-point rise in March 1997, a boost that Fed policymakers also described as a preemptive strike against inflation rather than a response to a price spiral.
Although Chairman Alan Greenspan hinted of further hikes after that, the central bank did not act. Then, last summer the Asian crisis together with panics in Russia and Brazil caused global financial markets to totter, and the Fed reacted by cutting rates three-quarters of a point.
Analysts had predicted for some time that the central bank would take back a portion of those reductions, and the Fed said that is partly what it was doing.
Since last fall, the statement said, “much of the financial strain has eased, foreign economies have firmed, and economic activity in the United States has moved forward at a brisk pace.” As a result, it said, the full amount of last fall’s rate cuts “is judged no longer necessary.”
The confusion over Wednesday’s action stems partly from Greenspan’s testimony to Congress just two weeks ago that the economy’s current 4% annual growth rate was “unsustainable.” He said the central bank was prepared to take “preemptive action” to slow growth.
Some analysts had trouble squaring Wednesday’s mild action with such tough talk. “They didn’t have to announce the bias change” against further rate increases, said Nicholas S. Perna, chief economist with Fleet Financial Group in Boston. “It’s borderline bizarre.”
Some analysts traced at least part of the problem to the Fed’s decision in December to begin announcing when the central bank had changed its bias toward future rate hikes or cuts. They said bias announcements could muddy the Fed’s message.
“Greenspan is still a little green about being open,” said Ratajczak, the Georgia State forecaster. “He’s obviously left a lot of confusion about where [the Fed] is going.”
* FED IMPACT
Stock markets worldwide may benefit; borrowers won’t pay much more. C1
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Market Response: Relief
Stocks soared Wednesday as the Federal Reserve raised interest rates but hinted that a modest increase might be all that’s needed to quell inflation.
