Federal Reserve will punch up rates again
Holden Lewis
June 26, 2006 in Investing
The Federal Reserve will keep the punch bowl out of sight for at least six more weeks, investors and economists agree.
A Fed chairman
famously said that the central bank's job is to take away the punch bowl as soon as the party starts getting interesting: It starts raising rates when the economy is growing swiftly. By that definition, the Fed swiped the punch bowl two years ago, on June 30, 2004, and has never let go. Meeting eight times per year, the central bank has boosted short-term rates 16 times in a row, a quarter-point at a time, to 5 percent.
When it meets Wednesday and Thursday, the rate-setting Federal Open Market Committee is expected to raise the federal funds rate a quarter-point for the 17th straight time, to 5.25 percent. The Chicago Board of Trade's futures market has priced in a 100 percent chance of a quarter-point boost Thursday, plus a slight possibility of a half-point rise.
Immediate impact
Whether the federal funds rate goes up by a quarter- or half-point, the prime rate will rise an equal amount. The prime rate now stands at 8 percent. Some types of consumer debt, including the rates for home equity lines of credit and credit cards, are indexed to the prime rate, so they'll rise, too. If you have an equity line of credit or a variable-rate credit card, count on the rate going up.
The Fed has been raising rates to keep inflation under control. Its job has been complicated since Hurricane Katrina by the resulting rise in prices for oil and natural gas. Higher fuel prices have shifted the overall inflation rate higher, but the Fed pays more attention to what is called the core inflation rate, which captures prices for everything but food and fuel.
You want even more complications? There are many gauges of inflation, the best-known being the Consumer Price Index. The Fed pays more attention to an inflation measure called the PCE — the personal consumption expenditures price index.
The overall PCE rose 2.9 percent from April 2005 through April 2006, and the core PCE for the same period went up 2.1 percent. That 0.8-percent difference mostly comes from higher fuel prices. The Fed would like to see the core PCE number somewhere between 1 percent and 2 percent. At 2.1 percent, it's not far out of whack. But Fed Chairman Ben Bernanke has said that he worries that higher fuel prices will eventually result in higher prices.
"Financial markets believe that the current rate of inflation is above the Fed's comfort zone, which will lead to more rate hikes in the near future," says Frank Nothaft, chief economist for Freddie Mac. Note the word "hikes" in plural; he says investors believe the Fed will raise rates at the Aug. 8 meeting, too.
CPI worrisome, too
Lawrence Yun, senior forecast economist for the National Association of Realtors, acknowledges that the Fed favors the PCE measure of inflation, but he worries that it's paying a lot of attention to the CPI, too. He worries that the Fed was alarmed by the latest CPI numbers: a 4.2 percent overall CPI rate from May 2005 to May 2006, and a core CPI rate of 2.4 percent.
"From our perspective, the Federal Reserve is overly concerned with the CPI figure," Yun says. Higher oil prices and rising mortgage rates already are exerting a drag on the economy, Yun says, so there's little need for the Fed to pile on with more increases in short-term interest rates.
The Realtors are resigned to a quarter-point hike this time. "In August, we hope they pause," Yun says.
And put that punch bowl back on the table.
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What the Fed said: a translation
Fed holds rates steady again
Federal Reserve cuts rates again
Fed holds interest rates steady again
Fed holds steady for 4th time
Fed cuts short-term rates by a half-point