Fed Holds Interest Rates Steady but Warns of Inflation

The Federal Reserve warned Tuesday that it is leaning toward boosting interest rates soon but decided to leave rates unchanged for now and let the economy continue to rip.

The decision to leave rates alone was widely anticipated, but the warning was not. Investors reacted by wiping out a 108-point gain that the Dow Jones industrial average had racked up earlier in the day.

The Fed’s signal provided the latest sign that the U.S. economy, which the central bank had hoped to slow with two rate hikes this year, is continuing to roar ahead, producing more goods, services, income and jobs but also raising the specter of inflation.

“There are increasing signs that inflation is on an uptrend. There’s clearly a case for raising rates,” said David Hale, chief economist with Zurich Kemper Investments in Chicago. Nevertheless, he added, the Fed made a “split decision.”

Members of the agency’s policymaking Federal Open Market Committee conveyed an unmistakable impression of sitting on the fence. In their statement to the media, members pointed to encouraging and disturbing economic trends in nearly equal measure.

On one hand, policymakers said, recent improvements in productivity, or output per worker, which have helped keep inflation in check, “have been sustained.” On the other, they warned, “growth of demand has continued to outpace that of supply,” a sure-fire recipe for sending prices flying.

The Fed’s decision left the federal funds rate, the interest that banks charge one another for short-term loans, at 5.25%. However, its warning of future hikes helped nudge key market-determined rates to their highest levels in months.

The yield on the 30-year Treasury bond rose to 6.17%, a two-month high. The yield on the two-year Treasury note increased to 5.76%.

The Fed had hoped that the two quarter-point increases in the federal funds rate over the summer would slow the economy from its 4%-plus growth rate early this year to about 3%.

Analysts said policymakers appeared to be hoping that this time the market would adjust rates upward without resort to a third hike.

“They’re trying to send a signal to slow things down,” said Richard B. Hoey, chief economist of Dreyfus Corp. in New York. “I’d put this in the category of tapping the brakes.”

But recent reports suggest that the economy is doing anything but slowing, as confident consumers continue to snap up cars and other expensive goods in record quantities and factories continue to run flat-out.

In fact, the country seems to be booming along at such a powerful pace that some economists are raising their estimates of growth for the July-September quarter and the year as a whole.

Macroeconomic Advisers Ltd., a St. Louis forecasting firm , said a panel of 20 analysts, which had predicted that gross domestic product would expand at an annual rate of 2.7% after inflation in the third quarter, recently raised its estimate to 3.9%.

At that pace, the growth rate for the full year would be close to 4% for the third straight year.

According to traditional economic models, such feverish growth should spark inflation. But to the surprise of almost everyone, including Fed policymakers, the latest reports suggest that inflation remains very much under control.

Excluding volatile food and energy, consumer prices rose a mere 1.9% from August 1998 through this past August, the smallest year-over-year increase in the so-called core rate of inflation in more than three decades. Even when food and energy costs are included, consumer prices rose only 2.3% during that period.

Nevertheless, many analysts believe that conditions are now ripe for inflation to creep back into the economy.

Wages are beginning to rise with unemployment at its lowest level in three decades, and recovering Asian nations are putting upward pressure on prices as they again compete with the United States for oil and other raw materials. Crude oil prices have more than doubled since December.

Some analysts warn that once inflation reappears, the Fed will have to take more drastic action than is generally expected.

“The risks are definitely with higher inflation,” said David M. Jones, chief economist with Aubrey G. Lanston & Co. “There is a point at which the Fed is going to have to do more” than tap the brakes.

In warning that they are leaning toward a rate hike, policymakers employed a technique adopted only this year--occasionally announcing their “bias,” or policy tilt. The method has provoked substantial criticism from investors who charge that it muddies the Fed’s message.

Analysts said Tuesday’s announcement was meant in part to keep investors from treating the decision to hold rates steady as cause for a new buying binge.

It may also have been intended to bat down the widely held view that if the central bank did not act Tuesday, it would wait until next year for fear of drying up credit at a time when the year 2000 computer problem might cause people to withdraw money from the economy.

Even if the central bank does raise rates at its next meeting, on Nov. 16, the economy remains on track to break the record for the longest boom in U.S. history, in February. It is now in its ninth year of expansion.