Upset by what Fed didn't say

Rate boost was expected, but market stumbles after no hint of end to climb

July 01, 2005|By William Neikirk | William Neikirk,CHICAGO TRIBUNE

WASHINGTON - The Federal Reserve's statements are often more important for what they do not say. And what the Fed did not say yesterday moved the markets.

Optimism had abounded in the stock market that the central bank would signal an end to its campaign to gradually boost interest rates to a "neutral rate." No such luck.

Instead, the Fed not only raised its benchmark interest rate by another quarter of a percentage point, to 3.25 percent, its ninth such increase in a row, it also said it would continue increasing rates at a "measured" pace, a message that the end is not in sight.

The stock market immediately went south, with the Dow Jones industrial average dropping 99.51 points to close at 10,274.97. According to some analysts, an overly exuberant Wall Street had misread the central bank's tea leaves.

"Totally unjustified," economist Bill Hummer of Wayne Hummer Investments said of hopes that the Fed would signal a pause.

But the Fed didn't give a clue at what point its increases would stop. Some analysts said it might stop at 3.75 percent. Others said it could reach 4.5 percent to 5 percent sometime next year, likely after Chairman Alan Greenspan has retired.

Unless the economy shows some danger of tanking, said Brian Wesbury, an economist at Claymore Securities, the Fed will keep raising rates well into next year. So far, the economy has been rising at a solid though unspectacular clip. Many analysts fear the Fed could go too far with its interest-rate campaign and harm the economy.

In reading between the lines of the Fed's announcement, Wesbury noted that the central bankers changed their rhetoric on inflation slightly from their last meeting in May. Yesterday, it said "pressures on inflation have stayed elevated," even though long-term inflation remained contained.

Wesbury, a close observer of Fed statements, called this change "a ratcheting-up of concern" about inflation that would require higher interest rates.

The Fed also did not mention the existence of a "housing bubble" that many analysts fear could wreak havoc on the economy if it should burst. Greenspan recently talked of "froth" in some local housing markets but said it is not a national problem. Many private economists disagree with him.

"It's the 800-pound gorilla, a major risk factor," said economist Scott Anderson of Wells Fargo Economics.

Anderson said the Fed should not take direct action to deal with the housing bubble, or even talk about it, and Wesbury said it would only confuse matters if Greenspan and company addressed the issue in a public statement.

But Hummer and Dean Baker, an economist at the Committee on Economic and Policy Development, a Washington think tank, said the central bank should talk about the bubble openly because of its potential to cause financial disruptions.

Baker said he was not surprised that the Fed did not mention the housing bubble. He said Greenspan had played a big role in creating the bubble and now should take at least rhetorical measures to let out the air.

"He's obviously reluctant," Baker said. "I think that's very irresponsible." Baker estimated that the housing market is overvalued by as much as $5.2 trillion, or roughly $17,000 per person in the United States.

At yesterday's meeting, the Fed's policy-making arm, the Federal Open Market Committee, unanimously approved the increase in its federal funds rate. Commercial banks followed by raising the prime lending rate by a quarter of a percentage point, to 6.25 percent.

The committee's statement said its monetary policy remains "accommodative," in that it supplies enough money to the market to keep interest rates low enough to bolster the economy. "Although interest rates have risen further, the expansion remains firm and labor market conditions continue to improve gradually," it said.

The Fed intends to stop raising interest rates when they reach a "neutral" point, low enough to keep the economy growing solidly but high enough to discourage inflationary pressures. Its benchmark rate is at the highest level since August 2001.

In another area that could affect the economy, the threat of a trade war with China diminished yesterday when two U.S. senators agreed to postpone a pending vote on legislation that would impose a 27.5 percent tax on all Chinese-made products unless the Asian power revalued its currency.

Sens. Lindsey Graham, Republican of South Carolina, and Charles E. Schumer, a New York Democrat, announced their decision after a closed-door meeting on Capitol Hill with Greenspan and Treasury Secretary John W. Snow.

"They have convinced us that the likelihood of real progress with China on currency revaluation is very real and could occur in a very short while, the next few months," Schumer told reporters. "We have agreed in delaying a vote on our bill."

Added Graham, "We're showing flexibility to create a win-win situation."

The senators' decision to postpone the expected July vote until late fall provides some breathing room for the Bush administration, which has tried quiet diplomacy to encourage China's move to an openly traded currency. So far that approach has been fruitless.

The Chicago Tribune is a Tribune Publishing newspaper. Knight Ridder/Tribune contributed to this article.

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