The FOMC voted unanimously to raise the federal funds rate target on Tuesday to 3.5 percent. It was the fifth time this year (and the tenth time since June 30, 2004) that the Fed raised the funds rate target by 25 basis points. The post-meeting statement contained a minor adjustment that reflects the Fed's belief that economic conditions are better today than they were six months ago, but they aren't necessarily looking at an exceptionally robust economy:

From the June 30 Meeting: "Although energy prices have risen further, the expansion remains firm and labor market conditions continue to improve gradually."

From the August 9 Meeting: "Aggregate spending, despite high energy prices, appears to have strengthened since last winter, and labor market conditions continue to improve gradually."

The meeting statement says that the FOMC intends to continue to remove policy accommodation at a measured pace. There was no indication that Fed officials were ready to stop raising the funds rate target. The chart below depicts the fed funds rate target over the past fifteen years relative to the year-over-year change in the core PCE deflator (excluding food and energy prices). Notice that the fed funds rate target has now surpassed the rate of inflation, as measured by this index, since January 2005. While the Fed may not yet have arrived at a rate that satisfies their estimate of a "neutral rate", we are certainly closer to a neutral rate today than we have been for a long time. San Francisco Fed President Janet Yellen gives a range of 3.5 to 5.5 percent for the neutral rate.

HOW ARE MARKET RATES STACKING UP?
The Fed's conundrum was that long-term rates were headed lower even as they were raising the funds rate target last year and for much of this year too. In July, long-term interest rates have started to inch higher and 10-year note yields average 4.18 percent for the month. But the rising trend that began in July continued in early August. In the first week of the month, the 10-year note averaged 4.33 percent. Yields dipped a bit after the FOMC announcement but the average yield for Monday and Tuesday was 4.41 percent, an additional gain of 8 basis points over the previous week's average yield. Conventional 30-year mortgage rates are tied to 10-year yields, and these two series have been moving in tandem. Mortgage rates have also started to tick higher lately.

Short-term rates have behaved differently (than long-term rates) during this period - rising generally in line with the fed funds rate target. In July, 2-year note yields averaged 3.87 percent. In the first week of August, the yields jumped to 4.04 percent in anticipation of today's rate hike. Despite the fact that 10-year note yields have finally picked up steam in the past few weeks, we are still seeing a very flat yield curve. The spread between the 10-year note and the 2-year note was 28 basis points today - the same spread posted on the last trading day of June.

CONSUMER LOANS RATES WILL INCREASE
As soon as the Fed embarked on their policy to remove accommodation, economists began predicting that consumer spending would moderate due to higher lending rates. This is the major reason behind economists' forecasts of a moderating housing market. But in fact, since mortgage rates are tied to Treasury rates, and not the federal funds rate target, mortgage rates were lower after the FOMC rate hikes than before - just like average yields on 10-year notes. But long term Treasuries are starting to move higher and so are mortgage rates. If this trend continues, then housing activity will indeed moderate in coming months.

Consumers borrow when purchasing many large ticket items. Auto loan rates, personal loan rates and credit card rates decreased when the fed funds rate target fell, but not always by the same magnitude. The Fed eased policy by reducing the fed funds rate target 550 basis points over a three-year period. Bank loan rates on new cars fell 320 basis points from their peak rate in the fourth quarter of 2000 to their low in the second quarter of 2004. Of course, many car buyers probably took advantage of the lower loan rates offered by auto financing companies. Rates fell 467 basis points from their peak in the fourth quarter of 1999 and their low in the second quarter of 2003. Indeed, judging by the chart below, auto-financing companies closely followed Fed policy during this period!

Personal loan rates are higher than car loan rates because these tend to be unsecured loans. Rates decreased by 232 basis points from their high in 2000 to their low in 2004. Credit card rates fell 363 basis points from their high in 2000 to their lows in the fourth quarter of 2003. Due to robust competition in this market, where many credit card companies offer 0-percent interest on balance transfers, average rates fell more than on personal loans. But considering the sharp drop in the federal funds rate, one might have expected bigger declines in credit card rates. As short term rates rise, credit card rates will rise also.

THE BOTTOM LINE
Fed officials did not surprise market players with their 25 basis point rate hike on Tuesday. Even the post-meeting statement was little changed. Market players are waiting for the Fed to reach a neutral rate, but they don't know what that rate actually is because Greenspan continues to claim "they'll know it when they see it." Economists and market players are certainly expecting more Fed rate hikes this year. A market consensus is beginning to develop that the Fed will stop (raising rates) somewhere between 4 and 4.5 percent. At least, based on current market events. Should market and economic conditions change course, then all bets are off. (And the eventual funds rate target could be higher - or lower.)

Consumers should continue to see higher rates on home equity loans (banks immediately raised their prime rates on the heels of the Fed rate hike on Tuesday) as well as on car loans, personal loans and credit cars. The competition among credit card companies remains healthy, so you might still receive some more of those pesky 0-percent offers on credit card transfers in your mail box, but rest assured that they will be fewer and farther between!

Evelina M. Tainer, Chief Economist, Econoday