Fed Signals Hikes Will Continue

The Federal Reserve pulled no punches Thursday in its fight against inflation, boosting its benchmark short-term interest rate by a quarter point and signaling that it had no plans to stop the increases anytime soon.

The widely expected hike, the ninth since the central bank began raising rates a year ago, brings its federal funds target rate to 3.25%. The increase led major banks Thursday to boost their prime lending rates by a quarter point to 6.25%, which will lead to higher costs on home equity loans and other debt.

The move disappointed stock market investors, who had hoped the Fed would indicate that it would take a break from raising rates.

Instead, in a statement accompanying the rate hike announcement, the Fed reiterated what it had been saying for months: that it would continue to raise rates “at a pace that is likely to be measured.”

However, changes in the Fed’s statement since its last rate-setting meeting May 3 suggest that it saw improvement in the economy. The Fed said economic growth “remains firm,” while in May it said growth had “slowed somewhat.” The Fed also said Thursday that inflation pressures “have stayed elevated.” In May, the central bank said such pressures had “picked up.”

Based on those changes, “there’s nothing here to hint that the rate hikes might stop soon. If anything, the hint is the other way,” said Ian Shepherdson, chief U.S. economist for High Frequency Economics in Valhalla, N.Y.

“If they’re in the eighth inning, it’s going to be a long inning,” said Anthony Chan, senior economist at JPMorgan Asset Management, referring to a Fed official’s recent statement that the central bank was in the “eighth inning” of its tightening program.

Stock investors, who had bid up share prices in the spring partly on hope that the Fed might soon quit or pause its tightening, sent prices mostly lower Thursday after the Fed announcement. The Dow Jones industrial average dropped nearly 100 points.

However, yields on long-term bonds fell, suggesting that investors saw the Fed’s action as increasing the chance of an economic slowdown. The yield on the benchmark 10-year Treasury note fell to 3.91% from 3.98% the day before. It stood at 4.69% a year ago, when the Fed began raising rates. The 10-year Treasury yield serves as a benchmark for fixed-rate mortgages and other long-term corporate and consumer loan rates.

Thursday’s decline in long-term yields “suggests that the bond market is worried that the latest rise in the federal funds rate might very well slow the economy materially,” said John Lonski, chief economist at Moody’s Investors Service.

Indeed, some analysts fear that further rate hikes increase the risk of throwing the U.S. economy into recession. Each of the last two Fed rate hike cycles, in 1989 and 2000, led to recessions. Surging oil prices are beginning to damp U.S. and global economic growth, although inflation still remains largely under control, these analysts say. Lower long-term bond yields suggest that the markets believe inflation to be less of a threat than slower growth.

An inflation gauge favored by Fed Chairman Alan Greenspan, which looks at prices paid for personal consumption excluding food and energy, rose at an annualized rate of 2% in the first quarter, still low by historical standards.

However, other analysts see plenty of reasons the Fed will continue tightening. Economic growth, they say, is strong by historical standards, coming in at a 3.8% annualized rate in the first quarter. The Fed’s target for the federal funds rate -- what banks charge each other on overnight loans -- is still only about 1% after adjusting for inflation. That is far lower than it’s been in previous Fed tightening cycles, they say.

Some analysts also argue that the Fed needs to do what it can to slow a speculative bubble in the housing market that has been fueled partly by low mortgage rates.

The Fed’s stated goal is to boost its benchmark short-term rate to a level seen as “neutral” -- neither stimulating nor discouraging economic growth. But Greenspan and his Fed colleagues have not said what that neutral level is. Greenspan said recently “we will not know it until we’re actually there.”

Analysts differ widely in their estimates of what the neutral level will be, with predictions ranging from as high as 5% to as low as 3.5%. Bond guru Bill Gross of Newport Beach-based Pacific Investment Management Co. has suggested the Fed might even start cutting rates next year amid a slowing economy.

Speculators in the futures market generally are betting that the federal funds rate will be at 3.75% by year-end. The next Fed rate policy meeting is Aug. 9.

“We are clearly closer to the end than the beginning” of the rate hikes, said Lynn Reaser, chief economist with the investment strategies group at Bank of America in Boston. She forecasts that the Fed will stop at 4% early next year.

“Oil prices have acted as a braking factor on the economy, but low long-term interest rates have provided a significant amount of stimulus, so there is a significant offset,” Reaser said.

However, if the economy shows signs of markedly slowing in the next few months, the Fed could stop at 3.5%, Moody’s Lonski said.

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Text of the Fed’s Rate Statement

Here is the Federal Reserve’s statement Thursday on 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 3.25%.

The committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Although energy prices have risen further, the expansion remains firm and labor market conditions continue to improve gradually. Pressures on inflation have stayed elevated, but longer-term inflation expectations remain well contained.

The committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.