Federal Reserve Increases Key Interest Rate to 4.25%

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Federal Reserve Increases
Key Interest Rate to 4.25%

By Greg Ip
From The Wall Street Journal Online

The Federal Reserve raised interest rates for the 13th consecutive time Tuesday and suggested it would raise rates again, but also suggested it is less certain on its future rate actions than it has been in over a year.

The Fed, as expected, raised its target for the federal-funds rate, charged on overnight loans between banks, to 4.25% to 4%. That's its 13th consecutive quarter-percentage point increase in the rate target since June, 2004, when it stood at a 46-year low of 1%.

In the accompanying statement, the Fed said growth remained "solid", inflation excluding food and energy prices had "stayed relatively low," and inflation expectations were contained. But it also warned that the possibility of further erosion of spare productive capacity and high energy prices "have the potential to add to inflation pressures."

"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," the Fed said. That sentence suggests the Fed feels it has to raise rates further. But for the first time in almost four years, it did not describe monetary policy as "accommodative."

By dropping that word, the Fed acknowledged that at 4.25%, the federal-funds rate is no longer so low that it is clearly stimulating economic activity, and may be in the range of "neutral," a level that neither stimulates nor restrains economic growth.

The changes to the language are the most significant in over a year and reflect a recognition by the Fed that it is no longer as certain of its future actions as it was for the last two years.

But by retaining the use of the word "measured," albeit in different form from the previous two years, the Fed also sought to eliminate perceptions that the end of its tightening campaign was imminent. The word "measured," which it first introduced in May of 2004, has come to mean by a quarter percentage point per meeting. Markets expect the Fed to raise the funds rate to either 4.5% by next Jan. 31, Alan Greenspan's last meeting as chairman, or 4.75% on March 28, when Ben Bernanke is scheduled to be chairman.

The economy grew at a robust 4.3% annual rate in the third quarter in spite of sustaining hits from Hurricanes Katrina and Rita and sharply higher energy prices, and appears to be growing at about 3.4% in the current quarter, according to Macroeconomic Advisers LLC, a forecasting firm. That pace is at or above the economy's long run growth rate and suggests that spare business capacity and idle labor are being used up. Fed officials say the economy may already be operating at full capacity, which gives firms and workers more leverage to raise prices and wages.

Although inflation excluding food and energy has remained at about 2% in recent months, that's still near the top of the 1% to 2% "comfort zone" that some Fed officials say they prefer. And the unemployment rate, at 5%, is down to levels some economists say represents "full employment."

Still, Fed officials are less sure of how much they will raise them. At its current level, the funds rate is far less stimulative than it was in June of 2004, when it stood at 1%. The housing market appears to have cooled in recent months which could feed back into consumer spending and slow overall economic growth. Moreover, inflation has surprised Fed officials by not rising further already, leading some to suspect there are new forces, like globalization, working to contain price pressures.

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-- December 13, 2005