Fed raises short-term rates again

  The Federal Reserve raised a key short-term interest rate today, reassuring investors that major combat operations against inflation are not over.

The Fed's Open Market Committee increased the target for the federal funds rate a quarter point, to 2.5 percent. The prime rate will rise to 5.5 percent. Consumer loans based on the prime rate -- variable-rate credit cards and home equity lines of credit, for the most part -- can be expected to rise in the coming days and weeks.

Short-term rates have gone up 1.5 percentage points since the end of June. In that time, the Fed's rate-setting committee has met six times, and each time it raised the federal funds rate by a quarter of a percentage point. In today's after-meeting statement, the committee hinted that more rate increases are in store.

"With underlying inflation expected to be relatively low, the committee believes that policy accommodation can be removed at a pace that is likely to be measured," the panel wrote. "Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability."

In saying that "policy accommodation can be removed at a pace that is likely to be measured," the Fed means that it can raise rates gradually. The rate-setting body has been using the phrase "likely to be measured" for months now, and most observers take that to mean that the Fed will continue raising rates a quarter-point at a time.

"They're on a mission to inch it up to where their (rate) target might be -- nobody knows what it is, but it's not there yet," says Bob Walters, chief economist for Quicken Loans.

Investors and economists will study the Fed's words intently over the next few days to extract every shred of nuance. Wall Street looks for signs of any change in the Fed's attitude about inflation. Would the Fed continue to say that it would raise short-term rates at a "measured" pace? Or would the committee hint that it might leave rates alone at some point, if the economic data warrant it?

"Everyone is looking at the comments," says Doug Perry, senior vice president for Countrywide Home Loans. Perry expected the committee to retain the wording about increasing rates at a measured pace. Had the Fed abandoned that wording and replaced it with a pledge to consult economic data before deciding whether to raise rates, investors would feel less certain about what would happen at the next meeting, on March 22.

Since the Fed started raising short-term rates June 30, some unusual things have happened. Interest rates didn't go up across the board. Some short-term rates went up -- those on credit cards and home equity lines -- but some long-term rates have gone down, and other long-term rates have gone up only slightly in the last couple of months.

This process has been most dramatic in mortgages. The average rate on a 30-year fixed has fallen more than half a percentage point since June, and the average rate on a one-year adjustable has risen about an eighth of a percentage point.

Why would long-term interest rates fall while short-term rates rise? Because long-term rates reflect investors' expectations of inflation, and rising short-term rates are seen as anti-inflationary. If you look at long-term rates, such as the yields on 10-year U.S. Treasury notes, it's apparent that bond investors aren't worried about inflation. The yield on the 10-year Treasury has fallen about half a point since the end of June, when the Fed started its rate-hike campaign.

Price stability is only one side of the Open Market Committee's mandate. It is supposed to balance fighting inflation with stimulating the economy. If the Fed overstimulates the economy by keeping interest rates too low, inflation will rise. If the Fed clamps down too hard on inflation, the economy will grow sluggishly.

"I am beginning to believe that they're going to need to slow the pace (of rate hikes) down," says Christopher Burdick, director of economic analysis for the Schwab Center for Investment Research. "When you look at the bond market, particularly longer dated maturities, the bond market does not show any fear of inflation."

Burdick believes the Fed needs to pay more attention to its mandate to pursue maximum sustainable economic growth. He thinks the Fed should ditch the wording about raising rates at a "measured" pace and replace it with a phrase meaning that future rate decisions will depend on the economic data. "It would give the Fed both the flexibility and the transparency that it preaches," Burdick says.

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

Rates for auto loans, mortgages and longer-term home equity loans don't respond directly to the Fed's rate moves, and sometimes move in opposite directions.