- The Washington Times - Thursday, May 11, 2006

The Federal Reserve yesterday raised interest rates to their highest levels in five years and said further increases could be in store if inflation and economic growth stay too hot.

While the Fed’s rate-setting committee did not indicate that its campaign against inflation is over, it said it expects growth and inflation to slow in the months ahead in response to the large dose of rate increases it already has administered.

“Economic growth has been quite strong so far this year,” according to the unusually forthright Fed statement that appeared to be the first one written by chairman Ben S. Bernanke, who replaced Alan Greenspan earlier this year.

“The committee sees growth as likely to moderate to a more sustainable pace, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.”

Inflation still could be stirred up, the Fed said, by a sharp run-up in the cost of energy and other raw materials, but so far chronically high energy costs have not spread widely through the economy. People still expect inflation to remain low.

The Fed’s statement clarified Mr. Bernanke’s recent testimony, in which he said the Fed may pause for a while until it sees where growth and inflation are headed.

The Fed has raised the federal funds rate — which it uses to prompt banks to raise the prime rate and rates on other short-term debt like credit cards and home equity loans — to 5 percent from 1 percent in June 2004. Banks followed yesterday’s quarter-point increase with an increase in the prime rate to 8 percent.

The stock market ended the day mostly flat, while bonds and the dollar declined, with the greenback hitting a one-year low against the euro.

“The Fed has taken a slightly more hawkish turn” because recent economic reports suggest the economy isn’t slowing as much as expected from the first quarter’s robust 4.8 percent pace, said Bernard Baumohl, executive director of the Economic Outlook Group.

The Fed’s job “becomes hellishly difficult when the economy is in the process of transitioning to slower growth,” he said. “It’s during such turning points when economic indicators typically spew out lots of conflicting messages.”

The housing market clearly has slowed from its hectic pace last year, but the spending spree that has sunk consumers deeply into debt has shown little sign of abating this year. The Fed will want to see clear signs of a turnaround before it deems its work is done, Mr. Baumohl said.

The Fed has a thin line to walk in ensuring the economy slows as intended without stifling growth altogether, and coaxing the housing market to cool without going into a free fall. If the Fed signals that it is through raising rates, for example, that might cause a rally in the bond market that would reduce long-term mortgage rates and give a renewed but unwelcome boost to the housing market.

Analysts say one reason the Fed chooses not to clearly signal what its next move will be is to keep Wall Street traders and analysts guessing, preventing them from jumping to incorrect conclusions that could upset the delicate balance that it is trying to achieve.

Minutes of the Fed committee’s last meeting in March showed that most members thought they were nearing an end to their two-year-long campaign of raising rates at the end of committee meetings at six-week intervals, and would pause until further evidence of a need for action arose.

Richard Berner, economist with Morgan Stanley, said the Fed is free to pause during the next few months because a slowdown almost surely is in the works after the first quarter’s burst of activity. But he expects the Fed will have to raise rates by another half percentage point before the end of the year because of brewing inflation pressures.

High energy prices and hearty growth have raised consumers’ inflation expectations, he said, while “a weaker dollar is magnifying companies’ pricing power.”

Richard Yamarone, economist with Argus Research Corp., said the Fed would get behind the inflation curve if it pauses at its next meeting in June because of an acceleration in hourly earnings last month that shows wage inflation is heating up. The Fed views wage gains as not out of line, as they are consistent with the growth in productivity.

“The current economic soiree is not exactly a party that should be left unchaperoned,” Mr. Yamarone said. “While the economy is at a point in the expansion that usually experiences a bit of a pullback, to date there seems little sign of moderation in this partylike atmosphere.”

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