Wednesday, August 09, 2006

Fed holds rates for first time in two years

Fed holds rates for first time in two years
By Krishna Guha in Washington and Jennifer Hughes in New York
Copyright The Financial Times Limited 2006
Published: August 8 2006 19:15 | Last updated: August 9 2006 00:44

The Federal Reserve on Tuesday held US interest rates at 5.25 per cent, ending an unbroken series of rises that began in June 2004.

Financial markets appeared uncertain about how to react to what is – at least at this stage – only a pause in the rate-tightening cycle. Equities, bonds and the dollar were all whipsawed by the announcement.

The Fed statement signalled that it still saw inflation risks and could raise rates further. But it did not go out of its way to emphasise its hawkish intentions. One member of the policy making committee, Jeffrey Lacker, president of the Richmond Fed, broke ranks and voted for a rate increase – the first formal dissent since Ben Bernanke became Fed chairman this year.

Financial markets, which priced in a Fed pause following weak employment data on Friday, had difficulty interpreting the message. The S&P 500 swung between a 0.4 per cent gain and a 0.5 per cent loss, ending down 0.3 per cent at 1,278.14.

“The immediate reaction was positive because the Fed did not raise,” said Markus Schomer, chief economist at AIG Global Investment Group. “Then people looked over the statement and realised this is a genuine pause, not an end to the tightening.”

Bonds rallied, and short dated yields fell, unwinding the inversion of the bond market yield curve. Meanwhile, the dollar traded lower against the euro. But overall, reaction was muted.

Peter Hooper, chief economist at Deutsche Bank Securities, said: “That was what they were aiming for. They did not want this taken as a signal that they are done.” He said Mr Bernanke might not mind Mr Lacker’s dissent, which reinforces the Fed’s inflation-fighting commitment.

Figures earlier in the day showed unit labour costs rose at an annualised rate of 4.2 per cent in the second quarter, with productivity growth at only 1.1 per cent in the non-farm sector.

The Fed statement explained why it had ended its sequence of 17 successive rate increases.

In the past it only said there were suggestions of a slowdown but this time it said “growth has moderated from its quite strong pace earlier this year”.

It acknowledged, as in previous statements, that core inflation has been “elevated”, and that the combination of high levels of resource utilisation and energy prices “have the potential to sustain inflation pressures”.

But it expressed confidence that inflationary pressures “seem likely to moderate over time”.

It cited “contained inflation expectations” and the cumulative effect of past interest rate rises as reasons to expect inflation to ease. But, reflecting the unit labour cost picture, it no longer cited productivity gains too.

The statement noted “some inflation risks remain” and leaving open the “extent and timing of any additional firming”. This suggests the Fed retains a tightening bias, and it is more likely that its next step will be up.


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