US Federal Reserve raises target rate to 3%
(Bloomberg.com)
Updated: 2005-05-04 15:08

US Federal Reserve policy makers raised the benchmark U.S. interest rate a quarter-point to 3 percent and restated a plan to carry out further increases at a "measured" pace to head off faster inflation.

"The stance of monetary policy remains accommodative," the Federal Open Market Committee said in a statement released after the meeting in Washington. "With underlying inflation expected to be contained, the committee believes that policy accommodation can be removed at a pace that is likely to be measured."

Retaining the "measured" language suggests the Fed is confident it can contain inflation through a gradual increase in borrowing costs, without causing more of a slowdown in the world's biggest economy. The increase, the eighth straight since June, puts the overnight bank lending rate at the highest since just after the September 2001 attacks.

Clerk Renee Rosignol calls out a trade in the Euro Dollar Pit at the Chicago Mercantile Exchange, after the U.S. Federal Reserve nudged interest rates up for an eighth straight time, May 3, 2005. The Fed is nodding to mounting inflation pressures but still confident it can contain them with 'measured' increases. [Reuters]

"Pressures on inflation have picked up in recent months at pricing power is more evident," today's statement said. "Recent data suggest the solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices."

"The committee perceives that, with the appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal," the statement said. Labor markets "apparently continue to improve gradually."

The vote to raise the overnight bank-lending rate was unanimous.

Forecasts

All 104 economists surveyed by Bloomberg News expected a quarter-point increase. Reflecting debate within the Fed itself, a separate survey of 22 bond firms that trade government securities directly with the central bank showed that nine of the firms expected "measured" to remain in today's statement and five predicted it would be removed. The rest offered no opinion.

"They have a little bit of a dilemma, in that there have been some inflation straws in the wind and there have been some straws indicating weakness," said Robert McTeer, former president of the Federal Reserve Bank of Dallas, in an interview. "They tend to cancel each other out, and the default position is a quarter-point."

Chairman Alan Greenspan and the rest of the FOMC are trying to determine how high the overnight bank-lending rate needs to go to restrain inflation without hurting economic growth. Crude oil prices are up about a third over the past 12 months.

Since the last Fed meeting March 22, a government report showed that consumer prices excluding food and energy jumped 2.3 percent for the 12 months ending March. The Fed's survey of regional economies released in April said "upward price pressures have strengthened," while actual increases by retailers have "remained moderate."

Slowdown

"The inflation rate is beginning to move up a little bit," said former Fed Governor Lyle Gramley, now an economic adviser at the Stanford Washington Research Group in Washington, before the decision. "That's got to be a bit worrisome to any member of the FOMC."

The U.S. economy grew at a 3.1 percent annual rate in the first quarter, the slowest in two years. U.S. employers added 110,000 workers to payrolls in March, the fewest since July. Retail sales excluding automobiles fell 0.1 percent March, the first decrease since April 2004, as consumer confidence dipped to a five-month low.

Even so, in recent speeches Fed officials, including Governors Donald Kohn and Susan Bies, said the economy remains strong and suggested inflation is the larger concern.

"As the economy expands, our attention shifts a little bit more to the inflation side," Kohn said in an April 22 speech. That's becoming more of a threat to a stable economy than slowing growth, he said.

Debate on Wording

Fed officials, in the minutes from their March 22 meeting, debated concern about whether the "measured pace" wording limited their freedom. Ultimately the FOMC decided that the phrase doesn't necessarily "rule out either picking up the pace of firming or pausing" the increases, the minutes showed when released in April.

"The phrase "measured pace' has lost its usefulness," said David Resler, chief economist at Nomura Securities in New York, before the decision. "They've told us it doesn't mean anything. It doesn't limit what they do.

Some Fed officials including St. Louis Fed President Bank President William Poole have estimated that a neutral interest rate that neither fuels inflation nor brakes growth is between 3 percent and 5 percent.

Rate History

The Fed's target rate is now about equal to overall consumer price inflation, which was 3.1 percent at an annual rate in March.

The overnight bank-lending rate is the highest since September 2001, when the Fed lowered the rate 50 basis points five days after the terrorist attacks on the World Trade Center and the Pentagon that shut down U.S. financial markets for five days.

The steady increases in the policy rate since June so far has had little effect on market interest rates that determine what consumers pay on loans or earn from savings.

For example, the average rate on a benchmark 30-year fixed mortgage fell to a two-month last week of 5.78 percent compared with 6.25 percent when the Fed began increasing rates in the final month of June 2004, according to Freddie Mac, the second-largest purchaser of U.S. mortgages.

"Conundrum'

Bond investors, confident the Fed has inflation under control, also have kept yields low on government debt, something Chairman Greenspan told Congress in February was a "conundrum."

Yields on the benchmark 10-year Treasury note were at 4.19 percent this morning, down from 4.68 percent on June 29, the day before the Fed raised interest rates for the first time in a year.

Even with the first-quarter slowdown, the U.S. is the fastest- expanding economy in the Group of Seven industrial nations, as growth falters in Europe and Japan.

With today's action, the U.S. policy rate is 1 percentage point above the European Central Bank's refinancing rate, 0.5 percentage point higher than the Bank of Canada's overnight rate, and 1.75 percentage points below the Bank of England's base lending rate.

Fed Governor Ben Bernanke excused himself from policy meetings after President George W. Bush on April 1 named him to lead the Council of Economic Advisers. Bernanke's Senate confirmation hearing is pending.

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