Fed Holds Rates Steady but Warns Its Bias Has Shifted

The Federal Reserve, taking a first, very tentative step toward raising interest rates to slow the booming U.S. economy, said Tuesday that it has now “tilted” in favor of such a move.

Mild though it was, the action took a bite out of the stock and bond markets, nudging down the Dow Jones industrial average and pushing up the interest rates that determine the cost of everything from mortgages to business borrowing.

Coming after a string of good news that had some analysts convinced the economy had entered a new era, the Fed decision suggested that at least some of the old economic rules still apply. Among them: that very low unemployment will eventually result in higher wages, and that the revival of down-and-out foreign economies will eventually help raise the price of such crucial items as oil.

“This is a warning shot,” said Carl B. Weinberg, chief economist of High Frequency Economics, a consulting firm in Valhalla, N.Y. “The Fed isn’t doing anything right away. But they’re saying there are imbalances in the economy that worry them.”

By conventional measure, the most notable aspect of Tuesday’s meeting of the Fed’s policymaking Open Market Committee was its decision not to raise the short-term interest rates over which it has control, despite some signs that inflation may be reviving.

The Fed’s key short-term rate, the federal funds rate or overnight loan rate among banks, will remain at 4.75%.

But in announcing its decision to shift its “tilt” or “bias” in favor of a rate hike in the future, the Fed was making its first use of a little-noticed procedural change established in December.

That change, an attempt at greater openness, permits the central bank to immediately announce any “significant” alteration in its thinking about future policy, rather than keeping the shift secret for weeks after it occurred.

“There is much more punch to this change in policy bias than there was to ones in the past,” said David M. Jones, chief economist at investment firm Aubrey G. Lanston & Co. in New York. The decision to announce bias changes “gives the Fed a new weapon for pushing up market interest rates when it thinks the economy needs to be slowed,” Jones said.

In fact, that is what the Fed announcement did. In the bond market, shorter-term yields that would be most sensitive to any future Fed increase jumped after the news, with the yield on one-year Treasury bills rising from 4.85% to 4.91%, the highest since August.

But longer-term yields were up only marginally or were slightly lower, suggesting that bond traders may view the Fed’s vigilance as helpful in restraining inflation.

The Fed’s announcement immediately quashed a midday rally in both stocks and bonds. The Dow industrials gave up a 77-point gain to end down 16.52 points at 10,836.95.

Analysts have repeatedly expressed amazement about the U.S. economy’s ability to keep growing in the face of a shrinking labor pool, a declining unemployment rate and a string of global financial upheavals, and to do so without reawakening inflation.

Many analysts thought they saw the first signs of breakdown in last week’s announcement that the government’s chief inflation measure, the consumer price index, had taken an unexpected leap in April. The 0.7% jump was widely thought to justify the Fed’s issuing the kind of warning it did Tuesday or even raising rates to slow the economy and snuff out price increases.

But as if to complicate the Fed’s decision, new statistics issued while the central bank was meeting suggested that the economy may be slowing on its own, thereby reducing the risk of inflation.

Construction of homes and apartments plummeted 10.1% in April, the largest monthly drop in more than five years and the third straight monthly decline since housing starts hit a 12-year high in January.

The Fed’s explanation of its action reflected the confusing economic crosscurrents. In a news release, the central bank appeared to discount the importance of the consumer price index, saying that “trend increases in costs and core prices have generally remained quite subdued.”

Instead, it focused on a snap-back in American financial markets after a near-panic last fall; a partial recovery of damaged economies in Asia and elsewhere, which could compete with the U.S. for oil and other resources; tightness in the U.S. labor market; and continued feverish spending by American consumers.

“The [Open Market] Committee was concerned about the potential for a buildup of inflationary imbalances that could undermine the favorable performance of the economy,” the release said.

As a result, the release said in a passage that captured the obliqueness with which the Fed still expresses itself, the panel “adopted a directive that is tilted toward the possibility of a firming” in rates.

Some analysts criticized the Fed decision, saying it shows the central bank is wrongly trying to fine-tune the financial markets or the economy.

“The Fed only has the CPI to go on in worrying about inflation,” said John Ryding, senior economist with New York brokerage firm Bear Stearns & Co. To move toward raising interest rates on such thin evidence, according to Ryding, “means you’re either uncomfortable about the market or uncomfortable about growth, and the Fed shouldn’t be seen as being either.”

“The Fed is running the risk that it looks like it’s responding to a single number,” said Nancy Kimelman, economist with consulting firm Thomson Global Markets in Boston.

Others, playing down the Fed action, pointed out that only about half the time does the central bank actually raise or lower rates within six months of changing its bias.