Fed signals further US rate rises

Quarter-point increase takes cost of borrowing to 2.5 per cent w `Measured' promise eases market jitters

THE FEDERAL Reserve raised its key short-term interest rate yesterday by a further quarter point, and sent a strong signal it will continue its strategy of small and gradual increases in the months ahead.

Wrapping up its first session of the year, the central bank's policy- making Federal Open Market Committee increased its target federal funds rate from 2.25 per cent to 2.5 per cent - and used virtually identical language to describe the move as it did for the previous 25-point rate rise in December.

The Fed's stance "remains accommodating", it said, and coupled with "robust underlying growth in productivity," would continue to support economic growth. Despite higher energy prices, it added, current and future inflation prospects remained "well contained."

Exactly as in December, the FOMC judged the upside and downside risks to the economy to be balanced. And, using the words whose omission would have sent jitters through the markets, it said future rises in rates would be "at a pace that is likely to be measured".

Yesterday's rise is the sixth consecutive quarter-point increase since last summer, when the central bank began to nudge its benchmark short term rate up from a 45-year-low of 1 per cent.

"The chairman [Alan Greenspan] is very happy with the status quo," commented the former Fed vice-chairman, Alan Blinder. "He thinks the policy setting is right, and he wants to keep things exactly the same. Events since the last meeting haven't forced him to change his mind."

Bill Gross, of the PIMCO investment funds group, predicted the Fed decision would have a smaller long-term effect on markets. "They won't move much. If the economy continues to grow at a 3 or 3.5 per cent or so, then they'll go on racheting up rates, to 3 per cent or a bit higher." Even so the Dow and other Wall Street indices - slightly higher before the Fed announcement - moved further ahead afterwards, almost certainly in relief the Fed did not take more vigorous action.

The dollar has risen 3 per cent against the euro since 4 January, when the Fed released minutes of its last meeting on 14 December. These showed that policymakers believed the funds rate was "below the level" needed to damp inflation. The result was speculation that the Fed would move with larger, 50 basis point steps, in contrast to the "measured pace" thus far.

But the latest GDP figures, showing the US economy grew by just 3.1 per cent in fourth quarter of 2004, have dampened these expectations. This was the weakest quarterly performance in two years, held down by a surge in imports.

The main bright spot was strong consumer spending - though much of that went on goods from abroad.

The rise in short term rates contrasts with the decline in 10 year yields - a "monetary paradox" caused by massive Chinese and Japanese purchases of longer bonds to recycle their huge trade surpluses with the US. These have now become a major worry for the Fed, as it faces a current account deficit running at an annualised $650bn (pounds 345bn) - 6 per cent of GDP - and a forecast 2005 federal budget deficit of $427bn, according to the White House.

In his State of the Union address last night, President George Bush was expected to repeat his pledge to halve the budget deficit and impose real spending cuts across government, excluding defence and national security.

The Fed began to raise interest rates last summer to a level it considers "neutral", that neither hinders growth nor fosters inflation. Most analysts believe this to be 3.5 or 4 per cent - suggesting that several more rate increases are in the pipeline, barring a major slowdown in growth.

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