Fed Raises Funds Rate to 3.25%, Keeps "Measured" Plan

(Bloomberg) -- Federal Reserve policy makers raised the benchmark U.S. interest rate a quarter point to 3.25 percent and restated a plan to carry out further increases at a ``measured'' pace.
The Federal Open Market Committee's decision to keep the ``measured'' language suggests central bankers are concerned that low long-term interest rates outside their direct control are still stoking the economy, making it necessary for them to keep raising their overnight bank lending rate to head off faster inflation. Today's rate increase, the ninth straight, brought the Fed's target to the highest since June 2001.
``As far as the Fed is concerned, it's still on track to raise interest rates again,'' said former Fed Governor Lyle Gramley, now a senior adviser at the Stanford Washington Research Group in Washington. ``It suggests that the economy is still doing quite well, and that further increases in short-term rates lie ahead of us.''
The statement after the FOMC concluded its two-day meeting in Washington today said that monetary policy ``remains accommodative,'' suggesting there's still room to raise the target rate, that the expansion is firm and the job market is improving. ``With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured,'' the statement said.
Investors pushed bond yields down, comforted by the prospect that the Fed has inflation under control. The benchmark 10-year Treasury note rose about a half-point, pushing its yield down 7 basis points to 3.91 percent at 5 p.m. in New York.
Inflation
One phrase that changed concerned inflation. ``Pressures on inflation have stayed elevated, but longer term inflation expectations remain well contained,'' today's statement said. The text from the May 3 meeting had said pricing power was ``more evident'' and that pressure had ``picked up in recent months.''
Today's wording is ``a little bit more inflammatory from a semantic standpoint than their prior statements,'' said Diane Swonk, chief economist at Mesirow Financial Inc. in Chicago. ``The Fed is trying to send a signal that they think rates should be higher, whether it's bond yields or short-term rates.''
All 22 of Wall Street's biggest bond trading firms, the so- called primary dealers in government debt that trade directly with the Fed, predicted an increase to 3.25 percent, according to a Bloomberg News survey. Eighteen predict the Fed will raise its target rate to at least 3.75 percent by year-end. Forecasts for 2006 range from 3 percent to 5 percent.
Forecasts
Today's vote to raise the target rate was unanimous.
The statement shows ``the Fed isn't finished and will continue to tighten,'' said Sage Advisory Services Ltd. co-founder Mark MacQueen in Austin, Texas. Sage Advisory manages $3.8 billion. ``This has taken away the belief some market participants may have had that the Fed was about finished.''
Any major changes to the Fed statement, such as dropping ``measured,'' may wait until after Chairman Alan Greenspan presents the FOMC's semi-annual forecast to Congress on July 20, giving him a way to foreshadow the change before the next Fed meeting in August.
Greenspan and other FOMC members have been trying to interpret what the low level of long-term rates means for monetary policy. Yields on U.S. 10-year notes fell from 4.69 percent in the past year, even as the Fed raised the overnight bank lending rate by a total now of 2.25 percentage points.
`Conundrum'
Greenspan, who is 79 and whose term as a governor expires in January, has called the situation a ``conundrum'' that is ``without recent precedent.'' Economists including Chris Rupkey at Bank of Tokyo-Mitsubishi in New York say the Fed's increased openness under Greenspan may have contributed to lower bond yields by removing risks that the FOMC would surprise investors.
Today's statement reinforces that the FOMC takes a different view than some investors and economists about what the low yields signify for the economy.
David Rosenberg of Merrill Lynch & Co. in New York is among the economists who interpret the low yields as a signal of slowing growth worldwide that will force the Fed to stop raising rates. Bill Gross, chief investment officer and manager of the world's largest bond fund at Pacific Investment Management Co., said June 21 that an overnight rate of 3.5 percent ``is as much as the Fed can risk'' and that by the beginning of 2006 the central bank may begin reducing rates.
``Certainly they're going to 3.5 percent in August and maybe more, depending on what the housing market does,'' Gross said in an interview today.
Views Differ
Yet Fed officials in recent speeches expressed less concern about a potential slowdown than about so-called imbalances such as a record current account deficit, soaring home prices and low U.S. savings. Greenspan cited ``froth'' in the housing market on May 20. On June 15, Governor Donald Kohn said he was concerned about ``unusual imbalances.''
Today's statement reinforced that the FOMC sees strength in the world's largest economy. ``Although energy prices have risen further, the expansion remains firm and labor market conditions continue to improve gradually,'' today's statement said. Growth in productivity and monetary policy are both ``providing ongoing support to economic activity.''
The U.S. economy expanded at a 3.8 percent annual rate from January through March, an eighth straight quarter of growth exceeding 3 percent, a Commerce Department report showed yesterday. The economy expanded by 3.7 percent since the first quarter of 2004, the fastest among the Group of Seven industrialized nations. Low interest rates supported business investment spending and consumer purchases.
Economic Growth
With today's action, the U.S. policy rate is 1.25 percentage points above the European Central Bank's refinancing rate, 0.75 percentage points higher than the Bank of Canada's overnight rate, and 1.5 percentage points below the Bank of England's base lending rate.
The U.S. continues to grow even as oil prices reach records, while inflation remains tame. Crude oil for August delivery reached $60.95 a barrel on June 27, the highest since the New York Mercantile Exchange began trading the contract in 1983; the price was about $57 a barrel earlier today.
The Commerce Department said today its price gauge tied to spending patterns and excluding food and energy costs, Fed policy makers' preferred measure for tracking inflation, rose 0.2 percent last month and was up 1.6 percent from May 2004. The central bank earlier this year projected the price index would rise 1 percent to 2 percent this year.
Inflation
Not all of the economic data has been strong. Orders for durable goods excluding transportation equipment declined in three of the past four months. Retail sales fell 0.5 percent in May and employers added 78,000 jobs in the same month, less than half what economists expected.
The Commerce Department today said personal spending stalled in May after rising in each of the prior three months, while incomes rose 0.2 percent after a 0.6 percent gain in April that was the biggest this year.
Even so, robust housing price increases may be buoying consumer confidence, which rose to the highest level in three years in June, according to the New York-based Conference Board. Low mortgage rates, which are usually linked to the yields on 10- year Treasury notes, have fueled the surge.
The average rate on a 30-year mortgage fell to 5.53 percent from 6.25 percent over the past 12 months. Average U.S. home prices rose 12.5 percent from the first quarter of 2004 to the first quarter of 2005, according to an index tracked by the Office of Federal Housing Enterprise Oversight. Twenty-four states showed average home price gains ranging from 10 percent to 31 percent during the period.
``What may be quite critical here with these lower long-term rates than we ordinarily expect, is it potentially engendering inflationary forces?'' Greenspan told the Joint Economic Committee of Congress on June 9. ``That's something which, needless to say, we are focusing on very extensively.''

To contact the reporters on this story:
Alison Fitzgerald in Washington at afitzgerald@blooomberg.net;
Craig Torres in Washington at ctorres3@bloomberg.net