Interest Rates Back in the Limelight

In March, the Federal Reserve raised key short-term interest rates for the seventh time in nine months. As with other rate increases, policymakers said the decision was based on attempts to contain inflation.

The Fed raised the two key rates by 25 basis points (one-quarter percent) each, as it has done at each of its past six meetings. The increases came as no surprise, but they were couched in stronger language than the Fed has used since it began a rate-raising cycle in June 2004.

Because the Fed has signaled loudly that it plans a number of interest-rate increases, analysts have begun focusing more on what the Fed says than on what it does for clues about the future interest-rate policy. The popular verdict: Future rate increases are not only likely, but they could be greater than the usual 25 basis points.¹

Chasing a Balance

Raising the price of money might seem like a strange way to keep other prices down, but the thinking behind it goes something like this: Inflation is caused when too many dollars are chasing too few goods. By charging higher interest rates, the Fed is essentially reducing the supply of money. The shorter the money supply, the greater the demand for a dollar. Theoretically, this makes less room for businesses to raise prices, thus helping keep inflation in check.

The dilemma comes in trying to control inflation without stunting economic growth. Generally speaking, inflation is both caused by and a threat to steady economic growth. You may recall that when the economy began to contract in 2001, the Fed cut short-term rates to 40-year lows and kept them low for the better part of three years to help stoke economic growth. The policy worked its magic on the economy, and when undeniable signs of steady growth emerged, the Fed began to raise rates again.

When you consider that raising interest rates too high can also squelch economic growth, it’s easy to see why setting interest-rate policy is a delicate matter.

Strong Language

Statements that accompanied previous interest-rate increases indicated that the Fed believed “inflation and longer-term inflation expectations remain well contained.”² By contrast, the statement issued with the late-March rate increases read, “Though longer-term inflation expectations remain well contained, pressures on inflation have picked up in recent months and pricing power is more evident.”³ Translation: Inflation is a greater threat today than it has been in a long time.

Critics of Fed policy fear a repeat of what they see as the Fed’s big mistake in 1999 and 2000. At that time, the economy was growing at about 4% per year, as it is today.⁴ With the stated goal of keeping inflation in check, the Federal Reserve raised the federal funds rate to 6.5% (more than double the current rate).⁴ Some observers believe that the Fed went too far and helped cause the recession that began in early 2001. These critics also point to evidence that peaks in Fed rate-hike cycles tend to contribute to financial crises.⁶ However, as if to vindicate the Fed’s inflation fears, the Consumer Price Index report, published one day after the March rate increases, showed consumer prices had risen 0.4% in February, the biggest jump since October 2004.⁷

The recent increase in inflation combined with the Fed’s heightened inflation fears have created uncertainty in the financial markets. Some companies will see higher short-term rates and higher inflation as positive news, while others will see these developments less favorably.

If you are concerned about how fluctuations in interest rates and inflation could affect your portfolio, please call. There are several strategies for managing these risks that may help position you to withstand market volatility.

1, 6) Investor’s Business Daily, March 23, 2004
2, 3, 5) Federal Reserve, 2000, 2005
4, 7) Haver Analytics, 2005

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