Federal Reserve Raises Rates
Dec. 13, 2005 — -- The Federal Reserve's Open Market Committee met today and voted to increase a key interest rate by a quarter-point to 4.25 percent. This is the 13th rate increase since June 2004 and brings the "Fed funds" rate to its highest point since May 2001.
The FOMC "tightens" monetary policy to keep inflation in check by slowing consumer demand.
The Fed has been fairly consistent in keeping a "measured" pace of rate hikes. That regularity is now in question as the governors have made the most significant change in their post-meeting statement in more than a year and a half.
Gone are references to "policy accommodation," which hinted that the rates were so low they were encouraging spending. Many economists are likely to say that we've reached a neutral level where rates are not spurring or slowing down economic growth.
What does remain is a reference to "measured policy firming." In the past, Fed watchers have believed this to be the governors' way of telegraphing a quarter-point hike at the next meeting.
The governors meet again on Jan. 31 for the first meeting of 2006. Chairman Alan Greenspan will end his 18-year term heading the nation's central bank at this meeting.
What does this mean? Inflation has become a real concern as energy prices have increased in the last year (oil up 50 percent in a year). But that concern seems to be going away.
"Despite elevated energy prices and hurricane-related disruptions, the expansion in economic activity appears solid," said the governors' statement. "Core inflation has stayed relatively low in recent months and longer-term inflation expectations remain contained."
So does this mean rates are likely to stay the same in the near future? Probably not, as history shows that the governors often "overshoot" their neutral objective. Many Fed watchers believe we'll see one more rate hike.
How does a rate hike reduce inflation? When you increase interest rates, it becomes more expensive to borrow money for major purchases. Businesses and consumers tend to delay big purchases when rates increase, slowing demand and reducing the pressure to increase prices.
The opposite is also true. Reducing rates heats up demand and can keep the economy growing through tough times. After the Sept. 11 attacks, the Fed quickly dropped rates to historic lows to bring the economy quickly out of a recession.
How much does this matter? This is important. Many short-term credit vehicles like credit cards and home-equity lines of credit are directly affected by the Fed funds rate. Prime rate, a measure many consumers are familiar with, is exactly 3 percent above the rate changed by the FOMC today. Many "big-ticket" credit facilities such as mortgage rates and student loans will not be directly affected by today's decision, but they tend to move in the same direction as the Fed funds rate.
A good rule of thumb: Short-term or revolving credit will go up when the Fed hikes rates; long-term credit vehicles tend to move in the same direction, but at a slower pace.