Fed raises interest rates to 2.5%

Quarter-point increase comes amid slower hiring, relatively low inflation

`Drain the punch bowl a little bit'

February 03, 2005|By KNIGHT RIDDER/TRIBUNE

WASHINGTON - To almost no one's surprise, the Federal Reserve Bank nudged interest rates up another quarter-point to 2.5 percent yesterday.

What instead set Wall Street chattering is the environment in which policy-makers made their decision: less-than-robust hiring and relatively low inflation.

"If they were listening to me, they would not be raising interest rates today," economist Ray Perryman said. "The economy is not at the level we would call robust yet. The danger is every time you raise interest rates, you make investment look unprofitable."

Yet others say a tighter monetary policy is needed before obvious signs of an economy firing on all cylinders.

"In any economic expansion, you want to drain the punch bowl a little bit," said Joseph Quinlan, chief market strategist at Banc America Capital Management.

Impact of increase

In any case, the Fed's actions are key to more than economists' forecast formulas. Rising rates eventually hit ordinary Americans by increasing monthly payments for credit-card bills, and loans for cars and mortgages.

About 10 percent of borrowers have adjustable loans that are seeing interest increases, said Keith Gumbinger, vice president at HSH Associates, a financial publisher in Pompton Plains, N.J.

"There certainly are borrowers who are refinancing out of ARMs [adjustable-rate mortgages] they just got a short while ago," he said. "Their cost of credit has gone up rather sharply in a short period of time."

The unanimous vote among the Federal Open Market Committee yesterday marks the sixth time since June that policy-makers pushed up the federal funds rate - the interest that banks charge each other on overnight loans - from its 46-year low of 1 percent.

Even at 2.5 percent, interest rates remain at historically low levels.

As it has in previous meetings, the Fed pointed to robust productivity, moderate output and contained inflation as reasons for another rate increase.

"Labor market conditions continue to improve gradually," the Fed said yesterday in a statement.

Robert McTeer, who until last fall took part in these sessions as president of the Federal Reserve Bank of Dallas, said he agreed with his former colleagues' decision. "With the economy performing so well, we need to get rates back up into neutral territory, where they're not providing stimulus," he said. "So far, so good."

Still, McTeer added that he wouldn't advise too many more upticks.

"Once you get to 3 percent, I'd start being a little more careful about it," said McTeer, now chancellor of the Texas A&M University system.

Recent economic data has pointed to an improving, but not robust, economy.

Though U.S. economic activity continues to be healthy - up 3.1 percent for the fourth quarter - it was below expectations. And productivity gains have largely kept companies from adding to payrolls.

Sluggish employment gains cause Perryman to say the Fed could hold back from rate increases. "We haven't gained back all the jobs we'd like to gain," he said. "There's plenty of room for growth."

A research note released by Merrill Lynch & Co. last month after the December labor report points out that the Fed has never tightened policy in such a jobs market.

Increases in nonfarm payrolls have come in below 200,000 in six of the past seven months, the report says; "How many times in the past has the Fed been tightening policy in such an environment? Try never."

Even before this latest increase, Merrill Lynch was forecasting slower growth in 2005, said senior economist Sheryl King. "We're not caught in a full-blown economic expansion," she said.

But Dana Johnson, senior vice president and chief economist at Comerica in Detroit, said that today's economy is better able to adapt to changing conditions, including higher borrowing costs. "Businesses spot changes in demand faster, inventories and capital spending aren't volatile," he said. "You don't get big overshoots or undershoots like you used to."

Greenspan to testify

Fed Chairman Alan Greenspan could shed more light on policy-makers' understanding of economic activity in two weeks, when he is scheduled to testify before Congress.

Until then, economists say, the Fed will remain intent on combating any nascent inflationary pressures in the economy. So far, inflation has been muted.

Economists expect the Fed to continue raising rates in 25 basis-point increments to between 3 percent and 4 percent. "This particular Fed has a bias toward controlling inflation and giving a little more weight to that than promoting growth," Perryman said.

Its chairman has an eye on his legacy, economists said.

"It's his last year at the helm," Quinlan said. "The last way he wants to go out is with rising inflation."

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