When the Federal Reserve’s rate-setting committee meets Tuesday, it almost surely will raise short-term interest rates by a quarter of a percentage point.
The quarter-point hike is “baked in the cake,” as famished economists are fond of saying just before lunchtime. In all likelihood, the federal funds rate will rise to 4.25 percent from 4 percent, and the prime rate will rise to 7.25 percent from 7 percent.
Futures traders at the Chicago Board of Trade are betting that there’s a 96 percent chance that the Fed will raise the federal funds rate by a quarter point, and a 4 percent chance that it will go up half a point. These traders assume that there’s no chance that the Fed will stand pat.
It’s bad news for …
The rates on some types of consumer debt, such as credit cards, home equity lines of credit and some auto loans, are based upon the prime rate. So the increase will be bad news for car-shoppers and people who carry balances on their credit cards and home equity lines. It’s good news for savers who will soon stash their money in new certificates of deposit. The effect of the increase won’t be so clear-cut on mortgages and home equity loans, which are set by market forces and not by the Fed.
People think the Fed is going to raise rates because members of the rate-setting Open Market Committee believe that inflation remains a potential threat. By raising rates, they discourage borrowing, if only just a little. That reduces demand, which keeps prices from rising too fast.
We’re four years out of the most recent recession, and the Fed sees its task as keeping inflation between 1 percent and 2 percent. That’s high enough to keep clear of dangerous deflation and low enough so as not to distort buying and investment decisions.
The fed inflation target is …
Fed officials usually are reluctant to say explicitly that they want to keep inflation between 1 percent and 2 percent, but Janet Yellen, president of the Federal Reserve Bank of San Francisco, did just that in a speech this month. Yellen is an alternate member of the rate-setting committee.
She noted that in the 12 months ending in October, the Fed’s favored measurement of inflation, the core personal consumption expenditures index, was up 1.8 percent. That, she said, is in the “upper portion” of her “comfort range,” and “I’d be happier if this measure were somewhat lower.”
Yellen speaks for herself and not for the entire Fed, but her words probably reflect the central bank’s consensus. And that points to this month’s rate increase and probably another boost at the next meeting, Jan. 31.
A pause in the spring?
Economists and investors believe the Fed will stop raising rates, at least temporarily, in the spring. Yellen noted that inflation was 1.8 percent in the 12 months ending in October, but was at a 1.6 percent pace from May through October. “This suggests to me that core inflation has been essentially compatible with the Fed’s price stability objective, even in the face of a rather large oil shock that started well before Katrina,” Yellen said, implying that the Fed’s rate-increasing cycle is almost over.
For months the Fed has been saying that it “believes that policy accommodation can be removed at a pace that is likely to be measured.” That’s another way of saying that rates are low enough to stimulate the economy, and the Fed plans to keep raising them gradually.
At November’s meeting, the rate-setting committee’s members discussed when it will be appropriate to delete, or at least alter, the phrase. “While it seems unlikely that the end of the current tightening phase is yet at hand, there obviously will come a time when these two phrases are no longer appropriate, and other changes to the statement may be needed as well,” Yellen said in her speech.
Christopher Burdick, director of research for the Schwab Center for Investment Research, believes that the Fed soon will say that most of the policy accommodation has been removed — in other words, that the rate hikes are nearing their end.
“I think they have to emphasize that the forecasts for inflation and economic growth are even more important now than earlier in the tightening cycle,” Burdick says.