Fed Raises Key Rate Again, Hints Tightening Is Near End
The Federal Reserve on Tuesday boosted its benchmark short-term interest rate by a quarter percentage point to 4.25% and sparked hopes that it might be nearing an end to its 18-month-long credit tightening program.
The central bank, in the statement accompanying its 13th consecutive rate increase, no longer described its policy as one of “accommodation.” That word has served as Fed-speak for interest rates being low enough to encourage economic growth.
Removal of the description suggests that the Fed is closer to its target of a “neutral” rate level -- one that neither stimulates nor stunts growth, analysts said.
But the Fed also said that “some further measured policy firming is likely to be needed,” suggesting that further hikes are in store.
“The end is in sight, it’s just that we don’t know what that number is and they don’t know that either,” said Allen Sinai, chief global economist at Decision Economics in Boston. The Fed’s latest statement suggests that it may no longer raise rates in predictable, consecutive quarter-point increments, but it will still do what it takes to keep inflation at bay, he said.
“It’s just not as black and white as before,” Sinai said.
Nonetheless, some analysts immediately reaffirmed forecasts that the Fed’s benchmark rate will hit 4.75% or 5% next year, up from 1% in June 2004.
The Fed also said that “possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures.”
The use of the phrase “increases in resource utilization” -- referring to the low 5% unemployment rate as well as higher use of factories and other industrial capacity -- suggests that the central bank is concerned that a tightening labor market could push up wage costs, said Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, N.Y.
“It signals that the labor market has now moved again to center stage in the Fed’s analysis and policymaking process,” Shepherdson said.
Although higher wages are welcome for workers, Fed policymakers fear that rising pay scales could ignite inflationary expectations among businesses, making it easier for them to pass along higher costs to customers. Such expectations could be self-fulfilling, as was the case in the inflationary 1970s.
The economy, for now, is performing well with inflation under control, the Fed suggested.
“Despite elevated energy prices and hurricane-related disruptions, the expansion in economic activity appears solid. Core inflation [excluding food and energy] has stayed relatively low in recent months and longer-term inflation expectations remain contained,” the central bank said.
Investors generally cheered the news, interpreting a possible end to rate hikes as bullish for stock prices. Major Wall Street indexes rallied modestly, with the Dow Jones industrial average gaining 55.95 points to 10,823.72. Bond yields, however, fell only slightly.
The Fed statement was consistent with recent data showing the economy growing strongly amid robust business and consumer spending and a pickup in hiring after the ravages of hurricanes Katrina and Rita.
Recent economic data also suggest that inflation remains in check, thanks in part to gasoline prices that have fallen from their post-hurricane peaks and robust gains in worker productivity. Also, the nation’s 5-year-old boom in housing prices has been slowing, which also could reduce pressure on the Fed to try to ramp up mortgage rates.
Analysts, however, suggested that the economy and interest rates were now at a crossroads where the risks of a Fed misstep were greater.
“The central bank runs the risk of raising the interest rate too fast,” said Sung Won Sohn, an economist and chief executive of Los Angeles-based Hanmi Bank. “Historically, the central bank had overreacted to inflationary pressures, contributing to economic recessions.”
On the other hand, Sohn said, if the Fed stops too soon, inflation expectations could be heightened. That could push up mortgage rates and damage the housing market.
The hike in the Fed’s key federal funds rate, which banks charge each other for overnight loans, will lead to higher borrowing costs for individuals and businesses. Many banks on Tuesday raised their prime lending rates a quarter point to 7.25%, 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.
However, rates on certificates of deposit and other interest-paying vehicles will also rise, giving a boost to savers.
The next Fed policymaking meeting is Jan. 31, the last official gathering for retiring Fed Chairman Alan Greenspan. Analysts expect further changes in the Fed’s policy statement then, possibly to give a clean slate for Greenspan’s successor who, pending Senate confirmation, will be Ben S. Bernanke.
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Fed’s Statement
Here is the statement issued Tuesday by the Federal Reserve about 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 4.25%.
Despite elevated energy prices and hurricane-related disruptions, the expansion in economic activity appears solid. Core inflation has stayed relatively low in recent months and longer-term inflation expectations remain contained. Nevertheless, possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures.
The committee judges that some further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the committee will respond to changes in economic prospects as needed to foster these objectives.
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Outlook for other interest rates
Here is where some key interest rates stand and the outlook after the Federal Reserve’s latest boost in its benchmark short-term rate from 4% to 4.25%.
Item: Prime lending rate
Current rate: 7.25%
Outlook: Major banks raised the prime a quarter point Tuesday, matching the Fed’s rate increase. The prime, a benchmark for many consumer loans such as home equity credit lines, usually changes immediately with Fed shifts. The next Fed meeting is Jan. 31.
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Item: Money market fund yield (seven-day average)
Current rate: 3.48%
Outlook: Until the Fed stops raising rates, money fund yields are likely to keep climbing. The funds usually track Fed rate changes with a lag of six to eight weeks, so the average yield should be near 3.75% by late January.
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Item: One-year CD yield (U.S. average)
Current rate: 3.35%
Outlook: Certificate of deposit yields should continue to edge higher as the Fed raises rates, but the pace of increase typically has been much slower than with money market funds.
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Item: 10-year Treasury note yield
Current rate: 4.52%
Outlook: Bond rates take their cue from the economy’s strength and the outlook for inflation. Some analysts believe the relatively low level of Treasury bond yields, compared with the Fed’s rate, is a sign investors expect the economy to slow.
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Item: 30-year mortgage rate (Freddie Mac average)
Current rate: 6.32%
Outlook: Mortgage rates generally follow long-term bond yields. The 30-year mortgage rate has pulled back slightly from a recent high of 6.37%.
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Sources: Informa Research Services, IMoneyNet, Bloomberg News
Graphics reporting by Tom Petruno
Los Angeles Times
