Dec 2005 Financial News

Fed raises rates again

Dec 14, 2005

NEW YORK (CNNMoney.com) - The Federal Reserve raised the target for a key short-term interest rate Tuesday by a quarter of a percentage point. The rate hike was widely expected by investors and economists, as the economy continues to show signs of strength.

But the central bank also modified its closely watched policy statement, a move that many analysts believe is a sign that the Fed may finally be nearing an end to its campaign of boosting interest rates. Markets reacted positively to the news, but some cautioned that despite the change to the statement, the Fed may still need to raise rates several more times.

The Fed did keep the term "measured," a word it has used to describe its approach to monetary policy since its May 2004 meeting. But it got rid of the phrase "policy accommodation can be removed," language that Fed watchers have typically interpreted to mean that many more rate hikes were on the way.

Instead, the Fed said 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" and added that "the Committee will respond to changes in economic prospects as needed to foster these objectives."

The Fed has increased rates by a quarter of a point at its past 13 meetings, dating back to June 2004. The federal funds rate now stands at 4.25 percent, its highest level since March 2001. Banks use the federal funds rate to determine overnight lending rates, which affect how much consumers and businesses pay for various types of loans.

Hope had been building in the financial markets before Tuesday's meeting that the Fed would pause soon, since interest rates are approaching a so-called neutral level, a level that is supposed to keep the economy growing at a healthy pace without spurring a harmful pickup in inflation.

"I think there will be another quarter point hike or two. This is paving a way for a pause at some point early next year," said Tom Higgins, chief economist with Payden & Rygel, a money management firm based in Los Angeles. "This tightening cycle is long in the tooth."

To that end stocks, which were mixed before the announcement, moved higher following the Fed's decision. Bonds were trading slightly higher, pushing the yield on the 10-year Treasury note to 4.53 percent. (Bond prices and yields move in opposite directions.)

Will Ben keep hiking?
Tuesday's meeting is the second to last for Federal Reserve chairman Alan Greenspan, whose term ends in January. Ben Bernanke, a former Fed governor, will take over for Greenspan, and his first policy meeting as Fed chair will take place on March 28.

But one economist said that the market should not assume that Bernanke will pause at his first meeting, even with the change in the Fed's language.

"The stock market may be overreacting to the Fed's statement," said Michael Strauss, chief economist for Commonfund, a money management firm based in Wilton, Conn. "The Fed may go a little further. Rates are approaching neutrality, but the Fed recognized the vibrancy of the economy. It doesn't look like the Fed is done."

As such, the Fed indicated that inflation was something it was still keeping a close eye on but added that "core inflation has stayed relatively low in recent months, and longer-term inflation expectations remain contained." The Fed used the same language to describe inflation in its last statement in November.

The Fed also said that higher energy prices this year and the effects of Hurricanes Katrina, Rita and Wilma did not appear to be having a major negative impact on economic growth. "Despite elevated energy prices and hurricane-related disruptions, the expansion in economic activity appears solid," the Fed said.

Ethan Harris, chief U.S. economist with Lehman Brothers, said that the Fed probably has room to raise interest rates a few more times, since the economy has shown no significant signs of weakening despite some obstacles.

"It's a Reggie Bush economy, running around and leaping over all problems," said Harris, referring to the Heisman Trophy-winning USC running back known for his uncanny ability to escape would-be tacklers.

Harris added that it's worth noting that the Fed still kept "measured" in the statement. He believes this word might be removed when the Fed meets in January but said that even if that is the case, the market should really pay more attention to what the Fed does, not what it says.

"This is a baby step toward pausing," said Harris. "But the Fed keeps hiking. These are language changes. It's all talk. The action is quite clear. They are still hiking."

So how high could the Fed wind up going before it stops raising rates? Vincent Boberski, chief fixed income strategist with RBC Dain Rauscher, said that he expects the Fed to raise rates again in January and at Bernanke's first two meetings in March and May.

"The Fed is closing in on neutral but has further to go. Five percent is a reasonable level," said Boberski. "We'll get two hikes from Bernanke before pausing, and he'll want to get there pretty quickly."

Barry Ritholtz, chief market strategist with Maxim Group, a New York-based institutional firm, also said he believes the Fed will probably raise rates at its next three meetings, but that if the economy is still humming along at a robust pace, it could keep raising rates even after that. The reason? The Fed said clearly that it's still worried about inflation.

"It's not one and done, two and we're through or three and we'll see," said Ritholtz. "There is inflation in the system and the worst thing a central banker can do is let inflation get out of hand. So if you look at the fed funds rate and what neutral is supposed to be, 5 to 5.5 percent is not unthinkable."

Paul R. La Monica
CNN Money
Tuesday, 13th December, 2005
6:12pm
http://money.cnn.com/2005/12/13/news/economy/fed_rates/index.htm?cnn=yes