US rates rise but markets toast neutral Fed stance

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The Independent Online
US MARKETS soared yesterday as the Federal Reserve signalled that its first rise in interest rates for two years might not be followed by any more imminent increases.

The Federal Open Market Committee lifted the federal funds rate to 5.0 per cent from 4.75 per cent. It did not lift the discount rate. And it said that it had shifted back to a neutral bias in its policymaking, indicating that it was agnostic as to whether the next move should be up or down.

"Owing to the uncertain resolution of the balance of conflicting forces in the economy going forward, the FOMC has chosen to adopt a directive that includes no predilection about near-term policy action," the Fed said.

"The Committee, none the less, recognises that in the current dynamic environment it must be especially alert to the emergence, or potential emergence, of inflationary forces that could undermine economic growth."

Wall Street surged on the news. The Dow Jones jumped 155.45 points, or 1.4 per cent, to close at 10,970.80. The Nasdaq market soared 44.01, or 1.7 per cent, to 2,686.12

US Treasuries rose sharply, with the benchmark 30-year bond jumping one full point immediately after the statement. In late trading the bond was at 90.125, up more than one and a quarter points, while its yield fell to 5.96 per cent from 6.07 per cent - the lowest since 18 June.

Analysts said that the markets had been surprised by the decision to move to a neutral bias, interpreting it as a sign that rates would not be raised in August, but in October at the earliest.

Pat Dimick, senior market economist at Warburg Dillon Read, said: "The Fed has made it as friendly a 25 basis-point increase [as possible] by leaving the discount rate unchanged and changing to a neutral bias."

Ian Shepherdson, of High Frequency Economics, warned that the surge on Wall Street was a "knee jerk reaction". "Once the economists produce their views on it tomorrow it will all change."

He said all previous recent rate rises had been accompanied by a corresponding change in stance and too much should not be read into it.

The decision to raise interest rates had been heavily signalled by the Fed for months in advance. The Fed lowered rates three times at the end of last year, after the international economic crisis shook US financial markets.

"Since then much of the financial strain has eased, foreign economies have firmed, and economic activity in the United States has moved forward at a brisk pace," the Fed said.

"Accordingly, the full degree of adjustment is judged no longer necessary."

The markets had expected a quarter point rise, but some analysts feared that a half-point rise might be on the agenda.

They had also expected the Fed to come back again with further rises after the economic data for the first half of the year.

But the shift to a neutral bias reassured the market that the Fed might not raise rates in the near future.

The announcement leaves the Fed chairman Alan Greenspan with the maximum possible room for manoeuvre.

It shows the Fed is not reassessing the economy's direction in any fundamental way, but is making changes at the margin.

The last increase in US interest rates was in 1997, but apart from this the Fed has been reducing rates for four years. Low interest rates combined with a turnaround in US government finances, low energy prices and a strong dollar have helped to create America's benign combination of strong growth, low inflation and low unemployment.

Justin Urquhart Stewart, of Barclays Stockbrokers, said he expected that there would be a muted reaction to the rise in the City today. "It is short-term relief but the same issues are still there and the markets will be nervous."

Marian Bell, head of research at the Royal Bank of Scotland, said: "Although it was a change to a neutral bias, the statement that came with it made it feel closer to a tightening bias. The big game this year has been how to take some of the liquidity without scaring what is a vulnerable equity market."

Richard Jeffrey, the chief economist at CCF Charterhouse, said: "There may be increasing speculation that UK rates have to follow the US with a time lag that is surprisingly short.

"I would be surprised if the FTSE is able to make any new highs this year and would expect it to be below current levels by the year end."

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