Fed Sticks to Its Monetary Guns and Raises Short-Term Interest Rates

• The FOMC voted to increase the federal funds target rate by another 25 basis points, to 3.75%.
• Widespread devastation in the Gulf region, the associated dislocation of economic activity, and the boost to energy prices imply that spending, production, and employment will be set back in the near term, but will not be a persistent threat.
• Higher energy and other costs have the potential to add to inflation pressures. However, inflation has been relatively low in recent months and longer-term inflation expectations remain contained.
• Policy accommodation can be removed at a "measured" pace.

Based on the baseline assumption that the effects of Hurricane Katrina will be a temporary setback, and on the priority given by the Fed to inflation rather than growth risks, Global Insight now expects two more 25-basis-point rate hikes this year, taking the federal funds rate to 4.25% by year-end, and one more rate hike in early 2006, taking it to 4.50% in the first quarter of next year.

The Federal Open Market Committee (FOMC) continued on its path of measured tightening on September 20, voting for the 11th time in as many meetings to raise the federal funds target rate a quarter percentage point. The target now stands at 3.75%, 275 basis points above its 1.00% trough.

With respect to Hurricane Katrina, the Fed acknowledged that the widespread devastation in the Gulf region, the associated dislocation of economic activity and the boost to energy prices imply that spending, production, and employment will be set back in the near term. However, the Fed does not believe that this represents a "persistent threat."

The Fed stated that robust productivity growth is providing a solid impulse to the ongoing recovery. In addition, the Fed reiterated that core inflation remains relatively low and that long-term inflation expectations are contained. But it is concerned about the threat of inflationary pressures from higher energy prices. The Fed gave no indication of departing in the near future from its current path of measured rate hikes. However, one Board member dissented from the decision to raise rates at the September 20 meeting.