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Fed raises rates again
Central bank boosts key short-term rate another quarter point despite expected impact of Katrina.
September 20, 2005: 5:13 PM EDT
By Paul R. La Monica, CNN/Money senior writer
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CNN's Kathleen Hays reports on the Fed raising a key short-term interest rate another quarter point to 3.75 percent. (September 20)
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NEW YORK (CNN/Money) - The Federal Reserve raised a key short-term interest rate Tuesday and suggested more rate hikes are on the way, saying it believes the effects of Hurricane Katrina on the economy would be temporary.

The central bank's policy-makers boosted their target for the federal funds rate a quarter-percentage point to 3.75 percent, the highest level in more than four years.

For consumers, the increase in the fed funds rate, an overnight bank lending rate, means higher rates for credit cards, car loans and adjustable-rate mortgages.

On Wall Street, investors expressed disappointment, sending stocks lower after the announcement. (For more on the markets, click here).

The rate increase was the 11th straight since June 2004 as Alan Greenspan and other central bankers seek to keep inflation under control. In its heavily scrutinized statement, the Fed said that more "measured" rate increases were likely in the coming months. The Fed meets again on November 1. (For the full statement, click here).

The decision to raise rates was not unanimous however. Fed governor Mark Olson voted against rating rates. The last time that all Fed members didn't agree about a rate decision was in June 2003.

In the immediate aftermath of the hurricane, there was a growing call for the Fed to not raise rates at this meeting since some feared a rate hike could crimp growth in the short-term and possibly even send the economy into a recession.

The Fed acknowledged these concerns in its statement. "The widespread devastation in the Gulf region, the associated dislocation of economic activity, and the boost to energy prices imply that spending, production, and employment will be set back in the near term," the Fed said.

But it added that Katrina would not derail economic growth over the long-term. "While these unfortunate developments have increased uncertainty about near-term economic performance, it is the Committee's view that they do not pose a more persistent threat," it said.

In fact, some have argued that higher prices of oil, food and other consumer goods could be one byproduct of Katrina, not a slowdown. And the Fed appeared to indicate that it may be even more concerned about inflation than it was before Katrina.

To that end, the Fed pointed out that "higher energy and other costs have the potential to add to inflation pressures." It also said that "longer-term inflation expectations remain contained" while in previous statements this year, it had said that inflation expectations were "well contained."

Mark Zandi, chief economist with Economy.com, a research Web site, said the absence of the word "well" was significant. As such, he expects more rate hikes in the coming months.

"The Fed is growing more uncomfortable about inflation," said Zandi. "This is a more hawkish statement and signals that more tightening is on the way."

John Kosar, director of research with Asbury Research, an institutional investment research firm based in Chicago, added that the Fed's decision confirms what investors had reluctantly come to expect in the past week or so, namely that despite Katrina, the economy is not in danger of a severe slowdown and that more rate hikes were necessary.

"As time went on, I think that the marketplace became more familiar with what the damages from Katrina were," Kosar said. "The Fed put an exclamation point on that by raising rates again. They said there would be some short-term issues but that they don't expect Katrina to change much in the economy."

Wall Street didn't react so favorably though. Stocks, which were trading slightly higher before the announcement, lost all their gains following the announcement and finished the day in negative territory.

Further confusing matters, bonds rallied following the Fed news but then traded little changed, leaving the yield on the benchmark 10-year Treasury at about 4.24 percent. Lower long-term bond rates are typically associated with an economic slowdown. Bond yields and prices move in opposite directions. (For more on the bond market, click here).

Still, other strategists said that despite the Fed's aggressive talk about inflation, it must be getting closer to achieving the so-called "neutral" target for interest rates, a level meant to keep prices in check without jeopardizing economic growth.

Wan-Chong Kung, senior bond portfolio manager at First American Funds, said her firm believes a "neutral" fed funds rate is probably between 4 percent and 4.5 percent. In other words, at least one more quarter-point hike is likely in November and there could be two more after that at its December and January 2006 meetings. The January meeting is scheduled to be Greenspan's final meeting as Fed chairman.

"The Fed has more work to do. It really prizes its inflation-fighting potential," she said.

But some are worried that if the Fed keeps raising short-term rates even as the yield on the 10-year Treasury falls, then the yield curve could invert, meaning short-term bond rates move higher than long-term rates, which is often a harbinger of a recession.

"Sooner or later it will be appropriate for the Fed to pause, regardless of whether or not we get a signal in that direction," said Subodh Kumar, chief investment strategist with CIBC World Markets. "There is no reason for them to invert the yield curve. Inflation is contained and the economy is okay. I don't see a reason for them to take the risk of keeping raising rates."

And Jim Glassman, senior economist with J.P. Morgan Chase, said that in his mind, the risk of an economic slowdown from Katrina is still greater than the risk of higher inflation, meaning the Fed could have afforded to pause now.

"You don't need to see it in the numbers to know that there is an issue with the economy with New Orleans out of commission," Glassman said. "The effects of the hurricane may be temporary, but it's not clear what the rush is to move rates, what the urgency is. It's mainly a fear about inflation that hasn't shown up."

For more on the Fed and rates, click here.  Top of page

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