Fed raises rates, keeps ‘measured’ vow

05/04/2005

WASHINGTON (Reuters) - The Federal Reserve nudged interest rates up on Tuesday for an eighth straight time and repeated a pledge to use “measured” increases to quell an increase in inflation.

But a rare twist on a carefully choreographed release whipsawed financial markets. The Fed admitted nearly two hours later that it accidentally left out a planned reassurance about long-term inflation expectations.

That omission initially drove bond prices lower as traders saw it as a sign of growing Fed worries about prices. Bond prices rallied after the Fed issued a corrected statement.

The policy-setting Federal Open Market Committee without dissent voted to lift the key federal funds rate—which affects credit costs throughout the economy—by a quarter-percentage point to 3 percent, as expected.

“Pressures on inflation have picked up in recent months and pricing power is more evident,” the Fed said in a clear warning that rates will keep rising for now.

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

Despite acknowledging inflation worries, 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 quarter-point hikes rather than bigger ones.

KEEP ON HIKING

“To me this is an indication that they have absolutely no intention of stopping,” said Jason Bonanca, a foreign exchange analyst with Credit Suisse First Boston in New York.

He added the U.S. central bank does not appear to see higher rates as harming the economy.

The Fed’s concern about rising prices in a maturing economic expansion was apparently acute enough to override recent signs that growth may be flagging and to keep interest rates on an upward trajectory.

Bond prices ended higher after the Fed corrected its statement. After the glitch was rectified, benchmark 10-year notes gained 7/32s of a point in relief, bringing yields to 4.17 percent from 4.19 percent on Monday.

Stocks eked out gains after the Fed said it felt inflation expectations were in check. The Dow Jones industrial average finished up 5.25 points, or 0.05 percent, at 10,256.95. The Nasdaq Composite Index gained 4.42 points, or 0.23 percent, to 1,933.07.

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

The Fed tacked the clause about “appropriate” policy actions to its standard language on economic risks at its March 22 meeting, a signal it did not see itself as tied to small moves if larger ones were needed.

This impression was reinforced by Fed Governor Donald Kohn in a speech last month. “If the economy goes somewhere else, we’ll go somewhere else,” he said.

The economy has grown steadily since a brief 2001 recession but the pace is moderating in the face of costlier energy. First-quarter growth eased to a 3.1 percent annual rate from 3.8 percent in the final quarter last year.

KEY GAUGES WORRYING

More troubling to policy-makers 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.

The Fed worries about the corrosive impact of price rises on economic growth.

Oil topped $58 a barrel last month, a record price.

While the price had eased to around $50 on Tuesday, that is still well above year-ago levels and is keeping gasoline prices above $2 a gallon as the peak summer driving season looms.

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 just 0.6 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, threats to growth shift.

Kohn said last month 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 eventually pause in its rate-rise campaign. That remains a possibility as rates rise toward a level the Fed deems neutral, one that neither slows growth nor fosters inflation.

The Fed began 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 rate lies somewhere between 3 and 5 percent but the Fed has been loath to be specific.

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

The next policy meeting is on June 29-30, a two-day meeting that allows the Fed to prepare for semiannual economic testimony to Congress by Chairman Alan Greenspan.