Fed Raises Rate Again; Now What?
With 16th Straight Rise, Board Leaves Its Options Open

By Nell Henderson
Washington Post Staff Writer
Thursday, May 11, 2006

Federal Reserve officials raised a key interest rate again yesterday and signaled that they do not know whether they will need to move it still higher in coming months to prevent rapid economic growth from pushing inflation higher.

The policymakers suggested in a statement that they were keeping their options open, a message that disappointed many investors and analysts who had hoped for a clear sign that the Fed would pause in June and leave its benchmark interest rate unchanged after nearly two years of steady increases.

Stock prices fell sharply after the central bank's top policymaking group, the Federal Open Market Committee, announced its unanimous decision and issued a statement. But then stocks rallied, dropped and then rose again as investors reacted with confusion to the first FOMC statement in two years that did not hint at the central bank's likely next move.

"Some further policy firming may yet be needed to address inflation risks," the committee said, raising the possibility of at least one more rate increase.

At the same time, the FOMC suggested that it does not know how many, if any, more increases are in store and that it may pause at its next meeting in June if economic growth slows and inflation pressures ebb. The committee "emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook" in response to new data.

"The FOMC has opened the door for a pause, but this does not necessarily mean the FOMC will go through that door at their June meeting," wrote economists at PNC Financial Services Group Inc.

The committee agreed unanimously to lift its benchmark federal funds rate, the interest rate charged on overnight loans between banks, to 5 percent from 4.75 percent, its 16th consecutive quarter-percentage-point increase since June 2004.

"Economic growth has been quite strong so far this year," the committee said, expressing concern that a strong job market, high prices for energy and other raw materials, and other factors could increase inflation pressures.

But the FOMC also said it expected economic growth to slow as rising interest rates, a cooling housing market and higher energy prices crimp consumer spending. That should tamp down inflation pressures.

If the economy slows as forecast and inflation pressures ease, Fed officials probably will not raise the benchmark interest rate again anytime soon. But if their forecast is wrong -- if robust growth causes inflation risks to rise -- they might raise the rate again in June, and possibly again after that.

"The statement gives the Fed options either way," wrote Ian Shepherdson, chief U.S. economist for High Frequency Economics Ltd., in an analysis for clients.

The benchmark rate, now at its highest level in more than five years, influences many other borrowing costs in the economy. Major banks followed the Fed's action by raising the prime rate charged on business loans to 8 percent from 7.75 percent. Lenders are also likely to bump rates higher on many consumer loans, such as on credit cards, home-equity loans and mortgages. Savers will likely benefit as banks and other institutions raise rates paid on money-market funds and certificates of deposit.

Interest rates on long-term loans, such as mortgages, have been rising in recent months, though more slowly than short-term rates. The average rate on a 30-year fixed-rate mortgage is 6.67 percent, still relatively low by historical standards and not much higher than its 6.31 percent level in June 2004, when the Fed started raising rates, according to Bankrate.com.

The Fed started slashing its benchmark rate in early 2001, after the stock bubble burst and as the economy began sliding into a recession that lasted from March through November of that year. Fed officials lowered the rate from 6.5 percent at the start of 2001 to a four-decade low of 1 percent in June 2003 to encourage consumers to keep borrowing and spending through the recession and initially sluggish recovery that followed.

Those low rates allowed auto dealers to spur sales through zero-percent loans and other financial incentives. Mortgage rates plunged, with the average 30-year fixed rate dropping to a recent low of 5.23 percent in June 2003, helping fuel the housing boom.

The Fed held its benchmark rate at 1 percent until June 2004, when the economy appeared healthy enough that it no longer needed so much extra stimulus. Fed officials have been raising the rate steadily since then, aiming for a neutral level, one that should neither boost nor slow growth.

The economy grew at a very rapid 4.8 percent annual rate in the first three months of the year. But Fed officials believe the expansion will slow in coming months, projecting that the economy will grow 3.5 percent over the whole year, the same rate as last year.

But inflation moved slightly higher in March. Wages are rising, and oil settled at about $72 a barrel yesterday on the New York Mercantile Exchange -- all signs of inflationary pressures.

Meanwhile, the housing market has started to slow, but consumer spending and business investment have been brisk.

Many investors had expected the FOMC to indicate it was ready to pause because Fed Chairman Ben S. Bernanke had told Congress last month that even if inflation risks remained, "at some point in the future the committee may decide to take no action at one or more meetings."

Bernanke, who succeeded Alan Greenspan as Fed chief in February, also made clear that a pause would not mean the committee was finished raising interest rates, saying that a pause at one meeting "does not preclude actions at subsequent meetings."

But futures markets indicated that many investors believed the new chairman had virtually promised an interest rate pause in June, despite Fed officials' comments to the contrary.

As Jack Guynn, president of the Fed Bank of Atlanta, said in a speech last week, "Given the range of possibilities ahead, I believe this is not a time for the Fed to pre-commit to a particular course of policy."