Fed Raises a Key Rate by a Quarter Point, as Expected

05/03/2005

WASHINGTON (Reuters) - The U.S. Federal Reserve nudged interest rates up Tuesday for an eighth straight time, nodding to mounting inflation pressures while expressing confidence it can contain them with “measured” increases.

The U.S. central bank’s policy-setting Federal Open Market Committee unanimously voted to lift the benchmark federal funds rate—which affects credit costs throughout the economy—by a quarter-percentage point to 3 percent, as expected.

The Fed said spending has slowed in the face of higher energy prices but that the job market is improving.

Significantly, policy-makers repeated their expectation that policy stimulus can be removed at a gradual, or “measured,” pace—wording generally taken to mean a diet of smaller, quarter-point hikes rather than bigger ones.

The Fed has indicated its concern about rising prices as the economic expansion matures, apparently a worry acute enough to override some recent signs that growth may be flagging and to keep interest rates on an upward trajectory.

“Pressures on inflation have picked up in recent months and pricing power is more evident,” the Fed said a statement outlining its rate decision, which also increased the largely symbolic discount rate to 4 percent.

Stock and bond prices ticked lower after the Fed’s announcement while the dollar firmed.

The central bank said that with “appropriate monetary policy action,” risks to the U.S. economy would remain balanced between weaker growth and higher prices.

The economy has grown steadily since a brief 2001 downturn but the pace is moderating under the impact of more costly energy. In the first quarter this year, expansion in gross domestic product eased to a 3.1 percent annual rate from 3.8 percent in the final quarter last year.

More troubling to the Fed is that prices, measured by the Fed’s favored gauge—the personal consumption expenditures price index excluding food and energy—rose at an annual rate of 2.2 percent in the first quarter, the fastest since the end of 2001.

Policy-makers worry about the corrosive impact of price rises on the economic expansion, since they potentially filter through every layer of activity, from factories buying steel to consumers filling up their gas tanks.

Oil topped $58 a barrel last month, a record price. It had eased to around $50 on Tuesday but that remains well above levels a year ago and is keeping gasoline prices above $2 a gallon—high by American historical standards—as the peak summer driving season approaches.

While prices are picking up, wage growth is near a standstill. Last week, the Labor Department said worker wages in the first quarter edged up a razor-thin 0.6 percent—keeping the 12-month rise at 2.4 percent.

Officials have indicated in recent speeches that they are acutely aware that, as the expansion matures and slack in labor markets is slowly taken up, the threats to growth shift.

Fed Governor Donald Kohn said at a recent economic conference that it was natural for the U.S. central bank to focus on inflation, adding: “That’s probably become more of a threat to economic stability.”

Earlier this year, there was speculation the Fed might pause in its rate-rise campaign at some point. That remains a possibility as rates rise toward a level the Fed considers neutral, one that neither slows growth nor fosters inflation.

The Fed initiated a gradual course of interest-rate rises last June, when overnight rates stood at a 1958 low of 1 percent reached after 13 cuts that wrapped up in June 2003.

Economists say a neutral fed funds rate lies somewhere between 3 and 5 percent but the Fed has been loath to be specific as it assesses the course of growth and price rises.

With five more FOMC meetings to go, policy-makers could achieve a 4 percent federal funds rate this year with one gathering to spare.

There is a roughly six-week interval between policy sessions, with the next meeting a two-day one on June 29-30 that allows them to prepare for semiannual testimony to Congress by Fed Chairman Alan Greenspan on the economy.