The FOMC voted unanimously to raise the federal funds rate target on Tuesday to 4.25 percent. The Fed has raised its funds rate target at every meeting this year (after raising the target rate at five meetings in 2004). Each of these increases was a "measured" 25 basis points. But perhaps these measured increases are coming to an end. At least, that's how market players interpreted the change in December 13's post-meeting statement from the November 1 statement.
From the November 1 Meeting: "The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability."
From the December 13 Meeting: "The Committee judges that some further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives."
Until now, Fed policymakers had been suggesting that monetary policy was overly accommodative and that they were aiming for a neutral rate policy. Outgoing Federal Reserve Chairman Alan Greenspan has said the neutral rate is not a practical measure for monetary policy and he has refused to offer a level or range. Vice Chairman Roger Ferguson concurs with that sentiment. San Francisco Fed President Janet Yellen has offered a range of 3.5 to 5.5 percent for the (nominal) neutral rate - depending on the inflation rate and the path of the economy. It would appear that whatever the neutral rate is, the Fed is much closer to this rate today than it was in the past few months. But has the Fed really achieved the neutral zone for which they were aiming? At least they removed the phrase about policy accommodation from their statement.
The policy statement did suggest that the Fed will still need to raise the target rate from its current level of 4.25 percent, but the number of rate hikes - as well as whether or not they will be coming at every meeting in the beginning of 2006 - will be a question for market players and economists. Actually, there are two question marks: What will Greenspan do in January and what will Ben Bernanke, his nominated successor, do in March? Certainly, FOMC members are still worried about potential inflation given the run-up in energy prices and the current level of resource utilization. So, we will (most likely) see more rate hikes, but the range of forecasts coming from economists and investors will have a higher dispersion in the new year.
THE FED AND THE MARKET
The same issues that we faced all year appear to be with us currently as well. The spread between the 10-year Treasury note and the 2-year note is still positive, but has narrowed consistently over the past few months. Analysts and investors have probably gotten tired of mentioning the relatively low yield on 10-year Treasuries, but it remains low given the 13 Fed rate hikes we have experienced in the past 18 months. The most plausible explanation is that foreign investors (whether central banks or private ones) have purchased our long term Treasuries and have held down long-term interest rates. To some extent, it is also possible investors feel confident the Fed is doing the right thing with respect to inflation-fighting. In 2006, economists are looking for a larger spread between 2-year and 10-year note yields and many are predicting that the 10-year note yield will surpass 5 percent.
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 not changed very much - although market players did interpret the change to suggest that the Fed may be nearing the end of its rate-increasing cycle. Perhaps.
Earlier this year, a market consensus developed that the Fed would stop (raising rates) somewhere between 4 and 4.5 percent. While the Fed hasn't stopped at the lower end of that range, the possibility of it stopping at the higher end of that range is not out of the question, that is economic growth remains moderate rather than robust. But it wouldn't be out of the question to see two more rate hikes either, bringing the funds rate target to 4.75 percent within the next few months.
Consumers will 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 cards. 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 they will be fewer and farther between. And the deals will be less enticing with balance transfer fees!
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