More Fed rate hikes expected

WASHINGTON - The Federal Reserve will keep raising interest rates because it fears inflation more than the harm energy prices will do to growth, economists said.

The Fed raised rates as expected on Tuesday by a quarter percentage point to 3.75 per cent and stressed the economic impact from Hurricane Katrina will be temporary while soaring oil prices could fuel inflation.

It also dropped the word "well" from its statement that "longer-term inflation expectations remain contained" and, just as tellingly, repeated its sense that rates remained too low and could be raised at a measured pace.

"The Committee continues to see the removal of accommodation as the focus of policy and has given no indication that it is close to the end of that process," former Fed Board Governor Laurence Meyer and his colleague Brian Sack at Macroeconomic Advisers wrote in a note to clients.

Some in the bond market think the Fed may pause after November or in early 2006.

Fed fund futures swiftly moved to price in another rate hike before December, taking the overnight funds rate to 4 per cent.

But they see only a 50 per cent chance of another quarter point increase before March. Bond yields on 10-year US government Treasury notes fell somewhat after the Fed move.

However, the Fed meets twice more this year, on November 1 and December 13, and then again on January 31, the final meeting under Chairman Alan Greenspan, who then retires after 18 years at the helm of the US central bank.

If the Fed continues its campaign of quarter-point rate hikes, this would take the federal funds rate to 4.5 per cent, allowing Greenspan to hand over to his successor a policy set more forcefully against inflation. Fed watchers say this might appeal to Greenspan.

"You don't want to force the new chairman to open his term by having to make a a 50 basis point rate hike," said Ethan Harris, chief US economist at Lehman Brothers, who sees the Fed hiking to 4.5 per cent in January and then stopping.

Not that core US inflation is getting out of hand. The August consumer price index, excluding food and energy, was up 2.1 per cent from a year ago, while the overall CPI was up 3.6 per cent. But the Fed has to worry about future inflation.

So with unemployment coming down, a certain amount of US productive capacity temporarily constrained by Katrina, and with an estimated US$200 billion ($289.89 billion) to be spent on reconstruction, there are plenty of potential sources of inflation out there.

"Given that the Fed views the impact of the hurricane on growth as transitory, and that it remains concerned about inflationary pressures, we expect the (Fed) to continue to tighten steadily at upcoming meetings," said Barclays Capital economists Dean Maki and Christopher Wheeler. They see the funds rate peaking at 4.75 per cent in March.

The fact that Fed Governor Mark Olson dissented from the hike indicated the complexity of the decision in the wake of Katrina. But this did not appear to signal a wider split on the Fed, since he is not a monetary policy specialist.

"Unless upcoming speeches indicate that other FOMC (Federal Open Market Committee) members are beginning to shift their views, we do not believe Olson's dissent represents the start of a broader movement within the FOMC toward slowing the pace of rate hikes," Barclays wrote in a note to clients.

- REUTERS