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Fed raises another quarter
Central bank boosts key short-term rate to 3%, keeps 'measured' pledge; cites spending slowdown.
May 3, 2005: 5:25 PM EDT
By Paul R. La Monica, CNN/Money senior writer
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NEW YORK (CNN/Money) - The Fed raised a key short-term rate a quarter of a percentage point Tuesday, a move widely expected on Wall Street, and the eighth straight increase as the central bank tries to fight off inflation.

The fed funds rate, which banks use to determine the interest they charge for loans, now stands at 3 percent, still near historical lows but the highest that interest rates have been since September 2001.

In addition, the Federal Reserve's policy-makers said in their closely watched statement that they would probably keep raising rates at a "measured" pace, which many economists and investors interpret to mean more quarter-point hikes in coming months.

The Fed has been raising rates since last June in a bid to keep pricing pressures at bay. Soaring oil prices have sparked concerns that businesses would start passing energy costs on to consumers. But other recent reports show the economy hit a soft patch in the first quarter, raising fears of a slowdown.

The government said last week that gross domestic product (GDP) growth for the first quarter fell to 3.1 percent -- the slowest in two years. After that report, many economists attributed the weakness to higher oil prices.

The Fed alluded to this in its statement Tuesday.

"Recent data suggest that the solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices," the Fed said.

In March, the Fed also said that "the rise in energy prices, however, has not notably fed through to core consumer prices," but it removed that phrase from Tuesday's statement.

Those were the only notable changes in language from comments the Fed made when it last raised rates in March. In Tuesday's statement, the Fed said, as it did in March, that the job market continues to "improve gradually" and that "pricing power is evident". Both statements mean the Fed is still keeping a close watch on inflation.

But the Fed also issued a correction about two hours after its announcement saying it inadvertently dropped the following sentence from the original statement: "Longer-term inflation expectations remain well contained." That language appeared in the March statement as well.

The addition of this sentence indicated to some that while the Fed is talking a tough game, the central bank's not overly worried about inflation.

"The correction somewhat mutes inflation concerns," said Bill Davison, managing director of fixed income with Hartford Investment Management. "The market is looking in one direction today and that's for slower growth."

For more on the corrected statement, click here.

Market yawns

Still, some market observers said that Tuesday's statement was largely anticlimactic.

"When the rubber meets the road, this statement doesn't change anything," said John Norris, senior fund manager and chief economist with Morgan Asset Management, a unit of Regions Financial, based in Birmingham, Ala. "The Fed will continue to increase rates. The only thing that we do know is that they will continue on a tightening mode."

Investors went on a see-saw ride following the news. Stocks, little changed before the announcement, dipped at first, then turned higher, and finished relatively flat.

"The market reacted like a market that was expecting exactly what it saw," said Chip Hanlon, president of Delta Global Advisors, an investment advisory firm in Huntington Beach, Calif.

Treasury bonds barely budged at first, but rose modestly after the Fed corrected its statement. That drove the yield on the 10-year Treasury down to about 4.16 percent, from about 4.19 percent late Monday. Bond yields and prices move in opposite directions.

But there was also a sense of relief for some investors that the Fed seemed content to stick with its measured pace of rate hikes -- at least for now.

"This lends some comfort to the situation. In spite of slight economic weakness, the Fed sees no need to change its strategy. It's also not going to shut down the economy too quickly," said Jack Ablin, chief investment officer with Harris Private Bank in Chicago.

Nonetheless, bond investors still seem more concerned about a possible economic slowdown than a pickup in inflation. Even though the fed funds rate has risen from 1 percent to 3 percent since June, longer-term rates haven't moved higher, a phenomenon Fed chair Alan Greenspan called a "conundrum" in February.

Hanlon doesn't see this changing anytime soon. "The risk is that long-rates could fall even further. The conundrum continues," he said.

A pause after the August meeting?

To that end, Morgan's Norris said the Fed will probably raise rates another quarter point in June and again in early August. That would bring the fed funds rate to 3.5 percent, a level closer to the desired "neutral" level meant to keep the economy growing at a decent pace without sparking inflation.

"We'll have another tightening or two and then the Fed can pause. Twelve weeks from now, the Fed will hopefully see inflation is not terribly different from now and is not going to risk crushing the economy with more rate hikes," said Norris.

Still, traders are betting the fed funds rate will finish the year slightly higher. According to contracts trading on the Chicago Board of Trade, they're pricing in a fed funds rate of about 3.75 percent by year-end.

But Margo Cook, head of fixed-income management at the investment arm of the Bank of New York, agreed with Norris that the Fed could pause once rates reach 3.5 percent. She said that until the labor market shows more noticeable improvement, inflation is of little concern, even if oil prices remain high.

"Inflation doesn't worry me. The economy is just kind of muddling along here," Cook said. "The biggest cause of inflation is wage gains and they are pretty subdued."

The Fed, and the market for that matter, will have its next chance to see whether there are real signs of inflation on the labor front when the April job figures are released Friday. Economists are forecasting an increase of 175,000 jobs to the nation's payrolls and that hourly earnings will be up 0.2 percent.

And Hartford's Davison said that while investors seem to be brushing aside worries about more aggressive rate hikes for now, a stronger-than-expected jobs report could reignite fears about rising prices all over again.

"Inflation is still something to keep an eye on," said Davison. "The market has priced in a slowdown but if we do get a surprise on payroll day, we could see a sell-off in bonds."

For more about the markets, click here.

For economic commentary by CNN's Kathleen Hays, click here.  Top of page

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