The Fed Changes Its Tone

As widely expected, outgoing Federal Reserve Chairman Alan Greenspan made his exit by lifting the fed funds rate by another 25-basis points to 4.50 percent: the 14th increase since rates began to ratchet up in June 2004. The increase did not surprise the market, but traders and investors were clearly taken back by the Fed’s apparent change of tone regarding its interest rate policy.

 Until last Tuesday’s FOMC meeting, the central bank had used the word “measured” to describe its established policy of gradually increasing interest rates by 25-basis points at a time. The market got used to gradual increases and was pumped with the expectation that rate increases would stop this year.

 Based on the recent weaker than expected GDP growth and the fact that the Fed does not want to halt the economic growth, I believe rates may end this year at around 5 percent.

 But at the Fed meeting, a twist was thrown in that clearly makes you wonder what the Fed is planning and, at the same time, increases the uncertainty in the markets.

 The Fed took the word “measured” out and said that “some further policy firming may be needed” in order to keep inflation at bay. So now the debate will pit the word “measured” against the phrase “some further policy firming.” What this does mean? I think the Fed under the incoming new Chairman, Ben Bernanke, wants to make sure inflation is under control and is warning the market that it may have to increase interest rates by more than 25-basis points at a time if inflationary pressures mount, despite there being little evidence of that at this time.

 The fed funds rate is now at its highest level in close to five years. Consumers and businesses will have to ante up in order to pay for the higher expected financing costs. And given that the savings rate is negative; I believe the higher rates could impact spending down the road.

 The question is when will the rate increase stop? Some pundits believe at least one more rate increase will surface at the next FOMC meeting on March 28.

 I believe there may be another 50-basis point increase in the fed funds rate to 5 percent before the Fed decides to stop. But, should inflation resurface, we could be in line for even higher rates.

 Whatever the case, I believe higher rates will impact spending and this could lead to lower economic growth. For the stock market, renewed interest rate worries will again pressure trading.