RIYADH, 7 February 2005 — As almost universally expected, the US Federal Reserve policy-making arm, the Federal Open Market Committee (FOMC) raised its key overnight federal funds rate by 25 bps to 2.50 percent on Wednesday. This is the sixth straight increase since the FOMC first raised rates on June 30, 2004, from a 46-year low of 1 percent. In contrast, the European Central Bank kept its key rate unchanged at 2 percent for more than one-and-half years (since June 6, 2003).
The FOMC statement accompanying the decision was almost identical to the one in December, when it had raised rates the previous time. It indicates that the Fed is now less concerned about the recovery, despite the slight slowdown in real GDP growth in the fourth quarter of 2004, and beginning to focus on inflation as the key issue going forward. The key inflation indicator that Alan Greenspan favors is core inflation, the growth rate of the consumer price index, excluding the volatile food and energy components.
Recent data show that the core CPI inflation rate has remained steady at a monthly rate of 0.2 percent and an annual rate of 2-2.2 percent. This is tame not only by historical standards but also low compared to the last recession. As a result, most analysts expect the Fed to continue raising interest rates at a “measured pace” as it has publicly announced, throughout this year.
A minority of analysts expect that the Fed may take a breather at midyear to assess the situation. This slow but steady raise in the Fed policy rates has had a desired impact on long-term interest rates and inflation. The 30-yr mortgage rate have actually fallen since the Fed first started raising rates on June 30, 2004 by lowering inflation expectation.
Normally, when economic growth becomes too hot, it leads to higher inflation and an increase in inflation expectation along the way. This, in turn, will increase long-term interest rates which the Fed wants to avoid because it has a negative effect on investment and housing. Thus, the Fed has the delicate role of tweaking its short-term interest rates higher just enough so that it keeps long-term interest rates at reasonable levels without choking off economic growth. So far, it seems, the Fed has been successful.
As expected, the Fed decision had a positive effect on the US dollar which rose to a new three-month high against the euro to $1.286/euro on Friday. This may, in fact, mark the beginning of the end of the US dollar decline. Since reaching a bottom of $1.3666/euro on December 30, 2004, the dollar has regained 6.3 percent of its value as against the 7.3 percent loss it incurred in 2004.
Friday’s non-farm payroll data was disappointing, as was the ISM index, but these had little negative impact on financial markets. Although, job growth came in at 146,000 vs. market expectation of 200K, most analysts believe that there will be no more turning back to the days of job losses anymore, given that 2.2 million new jobs have been created in 2004.
(Khan H. Zahid, Ph.D. is Chief Economist and vice president of Riyad Bank. Email: [email protected])
