Bloomberg: Fed Raises Rate to 1.25%, Maintains `Measured' Pace

Fed Raises Rate to 1.25%, Maintains `Measured' Pace (Update5)

June 30 (Bloomberg) -- Federal Reserve policy makers raised the U.S. benchmark interest rate by a quarter-point to 1.25 percent and reiterated that further increases can come at a ``measured'' pace, as long as inflation remains ``relatively low.''

The first increase since May 2000 came on a unanimous vote, a sign that no Federal Open Market Committee member saw enough of an inflation threat to seek a more aggressive move. Economic developments that threaten stable prices may cause them to change their gradual approach to raising rates, the policy makers said.

``With underlying inflation still expected to be relatively low, the committee believes that policy accommodation can be removed at a pace that is likely to be measured,'' members of the FOMC said in a statement following their two-day meeting in Washington. ``Nonetheless, the committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.''

The Fed is changing course after a year of holding the overnight bank lending rate at the lowest since 1958 to ward off deflation and revive a job market that lagged after the 2001 recession. Thirteen cuts took the rate from 6.5 percent in January 2001 to 1 percent last June, the fastest plunge in Alan Greenspan's 16-year tenure as chairman. The U.S. has added 1.2 million jobs this year and some inflation gauges have risen.

``Although incoming inflation data are somewhat elevated, a portion of the increase in recent months appears to have been due to transitory factors,'' the statement said. The FOMC said the risks to growth and inflation for the next few quarters are ``roughly equal.''

Market Reaction

The benchmark 10-year Treasury note gained almost 7/8 of a point after the announcement, pushing the yield down 11 basis points to 4.58 percent, the lowest since May 5, at 5:15 p.m. in New York. The yield on two-year notes, among the most sensitive to Fed moves, fell 14 basis points to 2.67 percent after rising by almost a full percentage point this year.

Today's pledge to ``respond to changes in economic prospects as needed'' was foreshadowed in Greenspan's June 8 comments to an international monetary conference in London. At that time he said the Fed is ``prepared to do what is required'' should inflation exceed the Fed's forecasts.

``The statement is exactly as it should be,'' said John Roberts, head of trading in inflation-linked U.S. bonds at Barclays Capital Inc. in New York. ``They specifically gave themselves flexibility to act as they see fit and made it clear they will do what it takes to maintain price stability.''

Forecasts

The U.S. central bank is trying to raise rates to a level that allows for economic growth with low inflation, without disrupting the economy or investors as in 1994, economists said. The increase has extra sensitivity in an election year, as President George W. Bush faces criticism about his handling of the economy from Democrat John Kerry, a Massachusetts senator.

A 25-basis point increase was expected by 138 of 143 economists surveyed by Bloomberg News, and 22 of 23 of Wall Street's largest bond firms had predicted the Fed would maintain its call for ``measured'' rate increases. Investors had interpreted the language, adopted in May, as signaling a series of 25 basis point increases.

The fed funds rate influences borrowing costs for consumers and businesses, from mortgages to auto loans. Citigroup Inc., Bank of America Corp. and J.P. Morgan Chase & Co., the three biggest U.S. banks, raised their prime lending rates to 4.25 percent from 4 percent following the Fed move. Wells Fargo & Co., Wachovia Corp. and other lenders also raised their prime rates to 4.25 percent.

Some executives said the Fed increase simply ratifies that demand is strong and welcomed the move to keep the economy from overheating. ``The economy is getting better and it needs to get better at a nice, gradual rate,'' said Charles O. Holliday Jr., chairman and chief executive of DuPont Co., the second-biggest U.S. chemical maker, in an interview. ``It doesn't need to soar up because then it soars down too fast.''

Companies

The rate increase also may bolster the balance sheet of U.S. manufacturers such as Delphi Corp., the world's largest auto-parts maker, by reducing their pension and health-care liabilities, which are projected based in part on long-term rates. A quarter- point increase, for example, could cut each liability by $300 million, said Delphi Treasurer Pamela Geller.

``We'll feel a little bit in our short-term borrowings, but that will be dwarfed by the benefit to the balance sheet,'' Geller said.

Futures contracts on the federal funds rate show traders expect the U.S. central bank to raise rates by a full percentage point between now and December, or an average of 25 basis points over the next four Fed meetings, consistent with a ``measured pace,'' economists said.

``Unless we get a surprise, we'll see another quarter-point increase on Aug. 10,'' said Robert ``Tim'' McGee, chief economist at U.S. Trust Corp. in New York. ``The Fed has likely begun the process of raising rates up to as much as 3 percent by the middle of next year.''

Greenspan Era

In the past decade Greenspan, who became chairman in 1987 and was confirmed for a fifth term this month at age 78, always started tightening cycles with a 25-basis point move. On average during his tenure, the central bank has raised the benchmark eight times in the first year of each cycle.

Policy makers raised the so-called fed funds rate an average of 2.67 percentage points in six to 12 steps during three rate- increase phases since 1987, each lasting 11-12 months.

While inflation is rising in government measures and in private surveys, Greenspan this month told the Senate Banking Committee that inflation is ``not likely to be a serious concern.''

The personal consumption expenditures price index, a measure closely monitored by the Fed, rose 0.5 percent in May, the largest rise since September 1990, and is up 2.5 percent over 12 months. Minus food and energy, the index is up 1.6 percent since May 2003, within a range of stable prices defined by some Fed officials.

Inflation Measures

The Labor Department this month said the rate of core consumer price increases slowed to 0.2 percent in May from 0.3 percent in April. Wage costs, which tend to lag inflation, are rising more slowly. Unit labor costs rose at a 0.80 percent annualized rate in the first quarter, down from a 1.7 percent rate in the last year's final quarter.

For now, Greenspan is predicting weakening of commodity prices, somewhat slower U.S. economic growth, and international competition that will help control inflation for goods and services. That was reflected in today's statement that some measures of inflation have been ``transitory.''

`Transitory'

So far, the data have partly confirmed those forecasts. Crude oil prices have fallen about 16 percent from a record close of $42.33 per barrel on June 1. Orders for goods made to last at least three years dropped for a second month in May, suggesting corporate spending may be moderating. An index of growth for Chicago-area businesses fell more than expected in June as orders and production slowed, the National Association of Purchasing Management-Chicago said today.

Other indicators remain strong. Low-cost financing helped push consumer spending up 1 percent in May, the biggest gain since October 1, and sales of previously owned homes rose to a record 6.8 million annual pace that month.

Inflation remains tame in Europe as well, and Japan continues to grapple with declining prices.

Inflation in the dozen euro nations slowed in June, easing pressure on the European Central Bank to raise interest rates as the economic recovery gathers pace. Japan's consumer prices excluding fresh food fell 0.3 percent in May. The Bank of Japan's Tankan index measuring optimism for large manufacturers probably rose to 17 this quarter, the highest since Japan's asset bubble burst in 1991, according the median forecast in a Bloomberg poll.

Bush and Greenspan

President Bush reappointed Greenspan to a fifth term as Fed chairman and the Senate confirmed him June 18. Greenspan's Fed has raised interest rates in previous election years as well, and Bush's advisers say markets are well-prepared for the change.

``As the economy grows and jobs are being created, I think it's always expected that a rate increase would be part of that strengthening in the economy,'' White House spokesman Scott McClellan said. `` It is a reflection of our strong economy that these things might happen.''

The Fed raised the benchmark in 1988, when the current president's father, George H.W. Bush, beat Democratic nominee Michael Dukakis. The rate also rose in 2000, when the current president beat Democratic nominee Al Gore.

Election Year

The first President Bush blamed his 1992 loss to Bill Clinton in part on the Greenspan Fed's failure to lower interest rates enough to boost growth. Officials from the current administration said that they too expect interest rates to rise.

Greenspan increased his visits to the White House in recent years, according to Fed documents. Last year, he met with White House personnel 68 times, versus 55 in 2002 and 37 times in 2001.

In the latest New York Times/CBS News poll, 40 percent of adults surveyed approved of how Bush is handling the economy and 52 percent disapproved. The survey of 1,053 adults was taken June 23-27.

In addition to today's benchmark interest rate decision, the Fed board also voted unanimously to approve requests by all 12 Fed banks for an increase in the discount rate. The rate, which the Fed charges banks for direct loans, rose a quarter-point to 2.25 percent.



To contact the reporter on this story: Craig Torres in Washington
at ctorres3@bloomberg.net

To contact the editor of this story:
Kevin Miller at kmiller@bloomberg.net
Last Updated: June 30, 2004 19:34 EDT