Fed raises interest rates; more hikes seem likely

Edmund L. Andrews

Wednesday, Sept. 21, 2005 | 9:39 a.m.

WASHINGTON -- Saying that Hurricane Katrina was unlikely to pose a "persistent threat" to the economy, the Federal Reserve raised interest rates on Tuesday for the 11th time in a row and signaled that more increases are on the way.

In an unusually long statement, the central bank acknowledged that the hurricane's devastation was likely to cause higher energy prices, higher joblessness and greater uncertainty in the months ahead.

But it said the hurricane had not shaken its confidence about longer-term growth, and it left little doubt that its top priority was still to head off inflationary pressures.

The decision lifted the federal funds rate on overnight loans between banks by a quarter-point to 3.75 percent, the 11th rate increase since the central bank began raising rates in June 2004.

"The widespread devastation in the gulf region, the associated dislocation of economic activity and the boost to energy prices imply that spending, production, and employment will be set back in the near term," the central bank's Federal Open Market Committee said in a statement.

But it continued: "While these unfortunate developments have increased uncertainty about the near-term economic performance, it is the committee's view that they do not pose a more persistent threat."

In a key hint about its desire to keep raising rates for a while longer, the central bank repeated its long-held expectation that "policy accommodation" -- meaning low interest rates -- could be reversed at a "measured" pace.

In a rare departure from Fed's normal unity, one member of the policy committee, Mark Olson, voted against the rate increase.

It was the first dissent since June 2003, and a sign that Tuesday's decision was unusually difficult.

But it did not necessarily portend a serious rift within the Fed. Olson, a commercial banker by profession, has focused primarily on bank regulation and has rarely taken strong stands on macroeconomic policy.

Edward McKelvey, a senior economist at Goldman Sachs, said policymakers are taking a much harder line about inflation than investors have been assuming.

"In our view, the financial markets are much too complacent about what a decision to keep tightening means at this juncture," McKelvey wrote before the Fed decision came out. "If under these circumstances the FOMC is prepared to keep going, then this means that the committee is more worried about the longer-term risk of higher inflation than the shorter-term risk of a collapse in growth."

In the first two weeks after Hurricane Katrina, many Wall Street analysts speculated that the Fed would either pause in raising rates or signal that the process would end fairly soon.

Historically, the central bank has taken a dim view of changing policy in response to a natural disaster, even a big one. Fed officials, and many economists, contend that the economic impact of such calamities is usually local and usually temporary.

The normal pattern is for the economy to slow and for unemployment to rise in the immediate aftermath. But any slowdown is usually followed by an even bigger jump in economic activity as rebuilding begins.

The big uncertainty this month is whether Hurricane Katrina, which disabled major oil refineries and offshore drilling platforms, will cause a more enduring downturn.

But the Fed, which has been raising the cost of borrowing since June 2004, showed little appetite for a "wait and see" approach.

It noted that the economy had been expanding "at a good pace" before Katrina. It also noted that "higher energy prices and other costs have the potential to add to inflation pressures."

Most important, it repeated phrases suggesting that money remains too cheap for comfort. It said the prospects for inflation and growth are "roughly equal." It implied that monetary policy is still "accommodative," meaning that interest rates are not yet back to a "neutral" level that allows growth without inflation. And it repeated its expectation about raising rates at a "pace that is likely to be measured."

Ethan Harris, chief U.S. economist at Lehman Brothers, said that neither the hurricane nor the surge in oil prices constituted a good reason to relax monetary policy.

Both the hurricane damage and higher energy prices amount to a "supply shock" that leads to higher costs. By keeping interest rates low, the Fed would be stoking consumer demand and possibly driving prices up even higher.

"There's not really anything you can do about a supply shock, other than repair the damage," Harris said. "As a policymaker you have to be very careful about putting a lot of stimulus into the economy at a time when capacity has been impaired."

Analysts continue to debate among themselves about how much more the Fed will raise rates. Most now predict that it will raise them at its two remaining meetings this year, in October and December, which would bring them to 4.25 percent.

In its statement, the Fed conceded that inflation remains mild and that higher energy prices have yet to drive other prices higher.

But Fed officials are increasingly concerned that low interest rates have fueled too much speculation in housing and too much complacency among investors toward risk.

Fed officials have also noted that long-term interest rates, which determine mortgage rates, remain as low as they were before the central bank started raising overnight rates. From that perspective, monetary conditions are almost as "accommodative" as ever.