Fed Kept Options Open on Rates

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By Nell Henderson
Washington Post Staff Writer
Thursday, June 1, 2006

Federal Reserve officials were so concerned at their last meeting about rising inflation that they considered raising interest rates more aggressively than they had in six years.

The U.S. economy has grown briskly this year, despite signs of cooling in the housing market. Payrolls and wages have risen. Energy and other raw-materials prices have climbed. The dollar has weakened. And consumers say they expect prices to keep rising faster.

"In view of the risk that the outlook for inflation could worsen," Fed policymakers agreed to lift their benchmark short-term interest rate to 5 percent from 4.75 percent at their May 10 meeting, for the 16th consecutive quarter-percentage-point increase in nearly two years, according to minutes of the session released yesterday.

But Fed officials also considered whether to bump the rate up by a half percentage point, to 5.25 percent, or to leave it unchanged, the minutes said in an unusually explicit description of the options considered. A half-percentage-point increase would have been the biggest since the Fed ended its last period of credit tightening with a similar-size increase in May 2000.

Members of the Federal Open Market Committee, the central bank's top policymaking group, "were uncertain about how much, if any, further tightening would be needed" after the May 10 increase, the minutes of the meeting showed . The group issued a statement that day leaving the door open to more increases in the future.

The Fed's uncertainty, compounded by reports of higher inflation, has roiled financial markets in recent weeks. The Dow Jones industrial average hit a six-year high May 10 and has been choppy since. Major international stock indicators have also fallen, reflecting anxiety over how high global interest rates may rise and how much economic growth may slow. Hedge funds and other big investors have pulled back from riskier global investments, fund managers said.

The Dow and other major U.S. stock indicators fell sharply yesterday after the Fed minutes were released at 2 p.m., as their hawkish tone led many traders and analysts to conclude that more Fed increases were likely. Stocks rallied to close the day with small gains, as many investors applauded the Fed's concern about inflation.

"This is good for stocks for them to sound more hawkish," said James W. Paulsen, chief investment strategist for Wells Capital Management, who attributed much of the markets' recent jumpiness to inflation worries.

Global markets will remain volatile and the big traders will probably retreat further from risky investment strategies as long as the outlook remains clouded for inflation, interest rates and economic growth, analysts and fund managers predicted.

"You've got a Fed that's not sure what they're going to do," said Larry Kantor, managing director of Barclays Capital Inc. The minutes, he said, are "not going to calm anyone down or reduce market volatility."

The minutes' implication that interest rates are likely to keep rising contrasted with recent comments by Fed officials, including Chairman Ben S. Bernanke, said Richard Yamarone, director of research at Argus Research Corp. "This is another in a series of confusing messages from the Bernanke Fed."

Bernanke told Congress in late April that he and his colleagues might pause after 15 consecutive interest rate increases. Such a pause would be based on the Fed's forecast that the economy will slow this year as higher interest rates cause the housing market to cool, prompting consumers to ease up on spending and tamping down inflation pressures. Some Fed officials have worried about raising interest rates too high, or "overshooting," and triggering a sharper economic downturn.

The economy grew at a rapid 5.3 percent annual rate in the first three months of the year, and many analysts forecast it to slow to a pace closer to 3 percent for the rest of the year. Several Fed officials believe an annual growth rate of 3 to 3.5 percent would be "sustainable" over the long term without fanning inflation.

Fed policymakers noted at the May meeting that the housing market had lost steam. Sales have fallen from their peaks last year, inventories of unsold homes are rising, and price appreciation is slowing. The Mortgage Bankers Association reported yesterday that mortgage applications fell last week to a level 22.4 percent lower than the corresponding week last year.

But FOMC members also noted that their desired slowdown had not arrived. Instead, exports were rising. Business spending on plants and equipment was robust.

The economy "had been growing quite strongly, and whether economic growth would moderate to a sustainable pace was not yet clear," said the minutes, which summarize the discussion without identifying participants by name.

Moreover, the officials agreed "inflation pressures appeared to be somewhat greater than the committee had anticipated" at its previous meeting in March. Fed officials "expressed some concern about recent price developments."

And if the Fed officials worried about overshooting at the May meeting, there was no mention of such concerns in the minutes -- in contrast to the previous meeting.

"Not one inflation gauge is trending [down] in a way that would support a pause," said Yamarone, who predicted that the Fed will raise its benchmark rate to at least 5.5 percent this summer. "They're all trending higher, and that has to be addressed by the Fed."


© 2006 The Washington Post Company

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