The quarter-point increase takes short-term rates to 3.75 percent, their highest level in four years. In its statement, the Fed said the devastation caused by Hurricane Katrina appears not to be posing a threat to economic growth. Inflationary pressure, it says, has increased because of higher gasoline prices.
Bill Gross, a respected bond investor in southern California, says he believes the central bank is likely to raise rates one more time until they reach the level of four-percent.
"Four percent seems a level, to my way of thinking, that is a neutral fed funds rate, given a two-percent core wholesale inflation rate and a two-percent core CPI [consumer price index]. From that point of view, Katrina aside, it seems the Fed is about to reach the promised land of neutrality [in monetary policy]," he explained.
Because Hurricane Katrina may result in short-term job losses of 600,000, some analysts had expected the Federal Reserve to pause in its process of steadily tightening monetary policy.
The central bank committee meets every six weeks to set short-term interest rates. Monetary tightening, or the raising of rates, increases the cost of credit and thus generally slows the pace of economic activity. The U.S. economy has been growing at about a three percent rate for the past two years. From 2001 until mid-2003 the Federal Reserve reduced short-term rates 12 times to stimulate a weak economy.
Since it usually takes 12 to 15 months before interest rate changes work their way through the economy, some experts fear an economic slowdown in 2007. Jim Smith, a finance professor at the University of North Carolina, says it would have been better for the Federal Reserve to have held interest rates steady at this meeting. One member of the committee did oppose the decision, meaning that the vote to raise rates was nine in favor and one against.
Higher short-term rates translate into higher monthly payments on credit card debt, automobile loans, and many home mortgages.