Fed raises rates as investors expect more

WASHINGTON, Aug. 10 (UPI) -- The Federal Reserve's decision Tuesday to raise rates yet again came as no surprise to Wall Street investors, but the question now is whether the Fed will continue to tighten policy as had been expected earlier this year, or if it will take a breather for a while.

Members of the policy-making Federal Open Market Committee, led by its chairman Alan Greenspan, voted unanimously to raise the key federal funds target rate by 25 basis points to 1.50 percent. It was the second time the Fed raised rates this year, having increased the funds rate by an equal amount at its previous meeting in June.

In explaining their decision to raise rates, the FOMC said that "the committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. "

But at the same time, policymakers acknowledged the downside risks, particularly higher energy prices.

"In recent months, output growth has moderated and the pace of improvement in labor market conditions has slowed. This softness likely owes importantly to the substantial rise in energy prices," the Fed said. Yet the central bank emphasized the overall buoyancy of the economy, with inflation remaining relatively under control.

Others were less upbeat than the Fed about economic prospects going forward.

This is "a slippery patch in the economy," and perhaps one of the trickiest as Greenspan faces his last 17 months in office serving his fifth and final four-year term as chairman, said former Federal Reserve Bank of Atlanta President William Ford. He added that the Fed cannot and should not ignore the downside risk of a potential continued rise in oil prices.

The Fed, meanwhile, said that it "perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters are roughly equal," with inflationary risks being "relatively low."

Some economists including the research group at Lehman Brothers expect the Fed to continue raising rates, with Lehman anticpating a rise of another 25 basis points, even at its next meeting in September despite the economy's weak spots.

Indeed, Joel Naroff of Naroff Economic Advisors also said that "given their confidence in the economy and the feeling that the inflationary pressures are, in their terms, transitory, it is realistic to assume that FOMC members will continue raising rates at each meeting for quite a while."

That's a sharp contrast to the Fed's moves over the past three years. The central bank had kept rates at 1.00 percent, its lowest level in over four decades, since June 2003 in an effort to keep the sluggish economy humming. Policymakers had embarked on an aggressive rate-cutting campaign in January 2001, when interest rates were at 6.50 percent. But the rapid decline of the economy, highlighted by the burst of the high-tech industry, pushed the Fed to slash rates on the one hand, while the Bush administration pressed ahead with significant tax rebates for households on the other.

For the past several months, Fed officials including Greenspan and heads of the regional Federal Reserve banks have made a point of emphasizing the success of the extremely low interest rates, as well as the tax breaks, in bolstering the broader U.S. economy.

Yet some Fed watchers are concerned that the Federal Reserve over-estimated the strength of the recovery, and they argue that the central bank should refrain from jacking up rates still further in light of the prevalence of continued weakness.

Certainly, the politically sensitive job market remains sluggish, according to the latest jobs report. The Labor Department reported last Friday that while the unemployment rate dipped to 5.5 percent, only a paltry 32,000 jobs were added nationwide in July, far below the general consensus of 200,000 non-farm payrolls being created.

"Unemployment above 6 percent in 2005 is becoming a genuine risk," said Peter Morici, an economics professor at the University of Maryland.

Meanwhile, consumer spending was reported last week to have fallen 0.7 percent in June, having gained 1 percent the previous month. Another factor weighing down the economy over the past few weeks has been the lackluster performance of the stock market, with the Dow Jones industrial average falling below the psychologically critical 10,000-level.

But perhaps most worrisome to economists is the continued rise in oil prices. Crude oil has reached over $44 per barrel, and some analysts argue that energy prices could go considerably higher before they start coming back down again. Higher energy costs will not only eat into shoppers' disposable income and keep consumer spending sluggish, it will also weigh down on corporate earnings as manufacturers will have to pay more for fuel whilst being less able to pass on the additional costs to consumers in a globally competitive environment.

At the same time, however, higher energy prices is likely to push up inflation, and that in turn could be an incentive for the Fed to keep raising interest rates higher in an attempt to keep down inflationary pressure, according to some analysts.

In the meantime, financial markets have welcomed the latest rate increase as a sign of the Fed's confidence in the economy, as the Dow Jones industrial average ending up 130.01 points to 9,944.67.

Fed policymakers are scheduled to meet three more times before the end of the year.