Fed raises short-term rates for 16th time
By Holden Lewis • Bankrate.com

The Federal Reserve has raised short-term interest rates for the 16th time in a row, lifting the target for the federal funds rate to its highest level in more than five years.

The federal funds rate, which banks charge to one another for overnight loans, rises one-quarter of a percentage point, to 5 percent. Rates will rise a quarter point on some credit cards and most home equity lines of credit because they are indexed to the prime rate, which goes up a quarter point to 8 percent. The prime rate rises and falls in lockstep with the federal funds rate.

Short-term interest rates haven't been this high since April 2001. Back then, the Fed did something highly unusual: Concluding correctly that a recession had just begun, the rate-setting committee convened an emergency meeting (a month before the next scheduled meeting) and cut the federal funds rate by half a point, to 4.5 percent.

Eventually, the federal funds rate bottomed out at 1 percent and the prime rate fell to 4 percent. Rates languished in the basement from June 2003 to June 2004. Then the Fed started raising in quarter-point increments. Nearly two years later, the federal funds rate has quintupled, the prime rate has doubled and borrowers are troubled, wondering when the hikes will end.

The Fed said the economy has been growing strongly and signaled that the increases probably haven't ended: "The Committee judges that some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information. In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives."

The phrase "further policy firming" is the Fed's way of warning of future rate hikes. The central bank granted itself some leeway, saying that future decisions depend on the economic data that come in.

Uncharted monetary waters
Whether or not the Fed is finished with this round of rate increases, the central bank might have ushered in an uncharted era -- one in which investors, business and consumers don't worry about inflation getting out of hand. Sure, there will always be inflation, unless we fall into another depression. But what if the Fed succeeds at keeping inflation tame for years on end? That question occupies Doug Duncan, chief economist for the Mortgage Bankers Association.

"We've got about a 50-year experience, with 25 years of rising inflation expectations -- which peaked in 1979 when (Fed) Chairman (Paul) Volcker came in and said we're going to change that -- then we spent 25 years disinflating the U.S. economy," Duncan told a recent gathering of real estate journalists in Charlotte, N.C.

He added: "Let's suppose you started your job at the age of 20 and now, 50 years later, your whole life has been spent either managing your household balance sheet in an inflationary environment or in a disinflationary environment. What happens now if the Fed is as good at keeping those inflation expectations low for the next 30 years? We have no one, either in the business sector or household sector, who has any experience in understanding how to manage their balance sheet in a noninflationary environment."

Searching for a benchmark
Duncan says the question to ask is whether households are adjusting their expectations based on inflation staying under control. It's not a rhetorical question; he doesn't offer an answer.

Economist Joel Naroff, principal of Naroff Economic Advisors in Holland, Pa., says it's too soon to declare the Fed's victory over inflation. First of all, he says, it's more accurate to call it a "nonaccelerating inflation environment" than to call it a "noninflationary environment." Less semantic is Naroff's second objection: What's the benchmark measurement of inflation?

The most familiar measure -- the Consumer Price Index, or CPI -- warrants only a curt nod from the Fed, like the plain girl trying to catch the eye of the quarterback at the school dance. The Fed seems to favor the plain girl's less volatile classmate, the chain-type price index for personal consumption expenditures. The central bank also pays respect to the chain-type price index for gross domestic product and the chain-type price index for gross domestic purchases.

There is no single measurement of inflation, or of inflationary pressures, that the Fed acknowledges using. "The fact that they've gotten away with this so long is amazing to me," Naroff says.

In his economic commentaries, Naroff enjoys pointing out that "core" inflation -- a measure of prices for everything but food and fuel -- has been running lower than overall inflation, which includes the price you pay at the pump and when you pay your electricity bill. The overall CPI was up 3.4 percent in the 12 months ending in March, and the core CPI -- all items except food and energy -- was up 2.1 percent. Over the same period, the chained personal consumptions expenditures went up 2.9 percent overall and up 2 percent excluding food and energy.

So if you don't eat, drive, or heat or cool your house, inflation isn't too bad -- around 2 percent. But if you do have an unfortunate fondness for gasoline, electricity and nutrition, your income might not be keeping up with inflation.

The Fed controls the federal funds rate indirectly, by selling and buying securities to add and subtract cash from the banking system. The prime rate is 3 percentage points higher, and moves up and down with the federal funds rate.