Fed Sets Quarter-Point Rate Hike

WASHINGTON (Dow Jones)--The Federal Reserve, citing continued inflationary risks, raised its key interest rate Tuesday by a quarter-percentage point for the eleventh time since mid-2004.

Noting still-elevated energy prices, Fed policymakers voted nine-to-one to lift the key federal funds rate 0.25 percentage point to 3.75% in a widely anticipated move that put the rate at its highest level in more than four years.

"The widespread devastation in the Gulf Region, the associated dislocation of economic activity, and the boost in energy prices imply that spending, production and employment will be set back in the near term," the central bank's Federal Open Market Committee said in a statement. The hurricane's damage may add to energy price volatility as well as raising premiums for some energy products, it said.

However, the Fed said even though the hurricane has raised near-term uncertainty, it doesn't "pose a more persistent threat." Monetary policy and robust productvity growth continue to support the economy, even as higher energy and other costs have added inflationary pressures, it said.

The Fed suggested another increase could be in store as soon as the next FOMC meeting on Nov. 1. As it has after each of the past 11 meetings, the FOMC said it can likely raise rates at a "measured" pace. So far this has preceded quarter-percentage point hikes at the next meeting.

The Fed again qualified its future interest rate policy by saying it would respond to changes in the economy "as needed" to keep prices stable. And it again said its monetary policy should help to keep a rough balance between risks to prices and economic growth.

The rate increase met the expectations of most financial market observers. Considering the Fed's core mission of maintaining stable prices, it had little choice but to continue hiking rates in the midst of sharply higher oil prices and the government's planned recovery spending for the Gulf Coast following Hurricane Katrina, many believed.

While sympathizing with human devastation on the Gulf Coast, Fed officials have made few public remarks on the hurricane's economic impact. One problem was a dearth of formal indicators so far to gauge the economic damage.

On Sept. 7, San Francisco Fed President Janet Yellen, currently a non-voting member of the FOMC, said the hurricane's potential to spur inflation and slow economic growth would complicate the Fed's already "challenging" upcoming interest rate decision. Katrina's damage would likely slow economic growth in the second half of 2005, but the economy would rebound afterwards as government-aided building gets underway, Yellen said.

In a speech the same day, a voting member of the FOMC seemed to tilt the balance of concern toward inflationary pressure. Chicago Fed President Michael Moskow signalled concern with longer-term inflation as a result of core inflation "running at the upper end of the range" he considers "consistent with price stability." If people begin to expect permanently higher inflation, their views could become self-fulfilling and damage longer-term economic growth, Moskow said.

Katrina spurred crude oil and gasoline futures prices to record highs at the end of August, as Gulf of Mexico oil and natural gas production and Gulf Coast refining were shut in. Meanwhile the huge post-Katrina rebuilding effort President George W. Bush promised to finance was expected to boost demand and prices for building materials and to raise government borrowing.

"If these inflationary considerations were not enough to stiffen the Fed's resolve to stick to its plans for future rate hikes, policymakers are also well aware that Katrina, like most natural disasters, will likely stimulate the economy," Milton Ezrati, senior economic strategist at Lord, Abbett & Co., said in an analysis ahead of Tuesday's meeting.

Core U.S. consumer price increases in August were tame at 0.1%, but some analysts have said the faster-growing overall consumer price index, which includes energy, may be more relevant in light of expected high energy prices for the foreseeable future.

U.S. unit labor costs rose 4.2% in the year that ended in June, the fastest rate in nearly five years, while workers' productivity growth slowed sharply. Fed officials had long anticipated a slowdown in productivity, and they have signalled particular concern lately with tighter labor markets, as unemployment dropped below 5.0% in August. "We probably can't count on slack to hold inflation down," said San Francisco Fed President Yellen.

Tuesday's decision to continue tightening should be seen as "quite hawkish" because it implies the FOMC is "more worried about the risk of an ultimate pickup in inflation than the risk of a near-term collapse in growth," according to Ed McKelvey, economist at Goldman Sachs. Taking this approach, the Fed could raise its key rate to 5.0% by mid-2006, McKelvey said.

Miller Tabak & Co. Chief Bond Strategist Tony Crescenzi also sees increased chances of the Fed reaching 5.0% next year if it decides to target restrictive - rather than neutral - policy. In key respects, financial conditions have actually loosened since the rate hikes began, with labor costs rising sharply, energy prices up and deficit spending due to rise next year for the Katrina recovery, Crescenzi said. "It might take a restrictive stance to achieve the objective of price stability," he said.

Pausing or even raising the risk of a pause in November would risk signalling to markets that the Fed is "falling behind the inflation curve," said Foreign Exchange Analytics currency strategist David Gilmore.

Moreover a pause in rate hikes at this point might have brought recently higher long-term bond yields back down, "frustrating the Fed's attempt to let the air out of the housing market slowly," Lou Crandall, chief economist at Wrightson ICAP, said in a research note ahead of the meeting.

Still, Crandall said the Fed funds rate is moving closer to the central bank's "long-run center of gravity."

The Fed may now have the federal funds rate close to its long-sought neutral territory, where monetary policy is no longer stimulating economic growth, Ezrati said. When the Fed began raising rates in the summer of 2004, indicators signaled a targeted level of 3.75%-4.0%, and "the basic economic situation still points in this direction," he said.