Fed raises rates but downplays oil fears

By SHIHOKO GOTO, UPI Senior Business Correspondent  |  Sept. 21, 2004 at 4:28 PM
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WASHINGTON, Sept. 21 (UPI) -- The Federal Reserve's decision to raise interest rates once again Tuesday took few by surprise. But the question now is whether the Fed will continue tightening monetary policy for the remaining months of the year, or whether it will take a breather after this latest meeting, with oil prices remaining the biggest unknown for growth prospects.

The Federal Open Market Committee chaired by Alan Greenspan voted unanimously Tuesday afternoon to raise the federal funds target rate by 25 basis points to 1.75 percent, and thus raising interest rates for three consecutive meetings. Policymakers made clear their optimism about the economy, moving forward, with strong productivity and steady job creation being expected.

"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," the FOMC stated in announcing its latest decision.

Policymakers did, however, caution that higher energy prices put a damper on growth, but only slightly.

"After moderating earlier this year partly in response to the substantial rise in energy prices, output growth appears to have regained some traction, and labor market conditions have improved modestly. Despite the rise in energy prices, inflation and inflation expectations have eased in recent months," the Fed said.

The rate had been at 1.00 percent, its lowest level in over four decades, for well over a year until this June, when the funds rate was raised by a quarter-percentage point, followed by a similar increase at the August meeting.

Yet while the June hike was in large part an effort by Fed policymakers from keeping the U.S. economy from overheating, economists are now more concerned about inflation and the possibility prices from getting rising too rapidly.

While many economists in public organizations argue that oil prices have not yet made a significant dent on economic growth, including researchers at the Paris-based Organization for Economic Cooperation and Development and analysts at the European Central Bank, there nevertheless is growing concern among investors that the continued rise in energy prices will lead to a significant rise in inflationary pressure against which the Fed has only one tool, namely monetary policy, to fight it with. Oil prices are now around $47 per barrel, and with strong and continued demand for petroleum worldwide, many analysts expect prices to climb higher, further pressured skyward by the continued turmoil in the oil-rich Middle East and Russian oil giant Yukos which is mired in financial difficulties.

Still, the Fed stated that inflationary pressure is expected to be "relatively low," adding that "policy accommodation can be removed at a pace that is likely to be measured."

The problem for the Fed, though, is that policymakers must continue to steer monetary policy with an eye towards the energy market even though the central bank has no control over setting oil prices, argued Ann Owen, a former Fed economist and an economics professor at Hamilton College.

By deciding to tighten policy this time around, the Fed can hope "to reduce inflationary pressures throughout the economy, but it cannot have a significant impact on oil prices and the increased interest rates will undoubtedly cost jobs. "

Meanwhile, former Federal Reserve Governor Alan Blinder, now an economics professor at Princeton University, said that the Fed might be belittling the possibility of oil prices posing a greater threat to growth.

The possibility of higher energy prices and resulting inflationary pressure "doesn't seem like it's over to me," Blinder said.

In the meantime, there is a price to be paid for trying to keep inflation under control by raising interest rates. The federal funds rate is the overnight rate at which the Fed lends to other banks, and a rise in the funds rate will inevitably lead to banks charging more to both consumers and businesses in providing loans. An interest hike therefore means that lending rates will go up across the board, and potentially lead to a decrease in business investment as well as a decline corporate and consumer spending.

But at the same time, had the Fed not raised interest rates this time around, it might have worried financial markets excessively, as Wall Street analysts may have fretted that the central bank was too concerned about the downside risks in economic growth to be worried about inflation.

"To hold off (would have sent) a signal that the economy was in trouble, the last thing the (United States) needs just six weeks before an election," said Brian Wesbury, chief economist at Chicago-based investment group Griffin, Kubik, Stephens & Thompson.

Granted, the Fed is a government agency that is politically independent, and it is not driven by the politics of the White House regardless of which party is in power. But even as an independent body, the Fed is sensitive to market reaction as well as political interpretation, and FOMC members have gone out of their way in recent years to make sure that market participants and policymakers can correctly guess how the Fed will move so as to not take them by surprise.

Moreover, Wesbury said that at the first post-election FOMC meeting scheduled for Nov. 10, the Fed is likely to raise rates yet again and perhaps take a break in December.

For now, though, Wall Street welcomed the latest rate hike as a sign of confidence by the central bank that the U.S. economy is still on track for growth. In trading Tuesday, the Dow Jones industrial average closed up 40.04 points to 10,244.93.

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