Fed: Rates Too Low to Curb Inflation

By Glenn Somerville

WASHINGTON (Reuters) - The U.S. Federal Reserve believed interest rates were too low to forestall inflation even after it raised borrowing costs in December, according to minutes of that meeting released on Tuesday.

"Even with this action, the current level of the real funds rate target remained below the level it most likely would need to reach to keep inflation stable and output at its potential," said the minutes of the Dec. 14 meeting, clearly pointing to more rate rises this year.

The central bank's wariness about inflation sent stock and Treasury bond prices lower as investors saw the Fed indicating higher borrowing costs ahead -- although economists did not see any change in the gradual pace of rate rises.

"A number of participants cited the recent depreciation of the dollar on foreign exchange markets, elevated energy costs and the possibility of a slowing in underlying productivity growth as factors tending to boost the upside risks to their inflation outlook," the minutes of the Dec. 14 meeting said.

But they added: "On net, they saw the risks to stable underlying inflation as still balanced."

At the Dec. 14 meeting, the Fed raised rates for a fifth time in the space of six months, up another quarter-percentage point to 2.25 percent. The U.S. central bank is widely expected to continue raising them when the FOMC next meets on Feb. 1-2.

Financial markets and economists concluded the minutes meant the Fed's policy of gradually bringing rates up from low current levels will continue for some time.

The minutes said some meeting participants also felt the prolonged stretch of cheap credit may have prompted "potentially excessive" risk-taking in financial markets -- citing narrow credit spreads, as well as an increase in initial stock offerings, mergers and speculative demand in the residential real estate market.

"Basically what they're saying is that given the rate in the bond market, people are taking excessive risk," said Christopher Low, chief economist at FTN Financial in New York.

"Some members said the economy is close to potential, which suggests we might soon see inflation pressures take hold. All in all, I'd say it's considerably more hawkish than what we've seen."

The minutes were the first released under a new policy adopted at the Dec. 14 gathering to speed up publication by issuing minutes three weeks after each of the eight-times-a-year meetings are held.

CLEARER RATE SIGNALS

The minutes said FOMC members felt faster release of the information "would help markets interpret economic developments and predict the course of interest rates."

"All that suggests they are on track to hike over the next several meetings," said Paresh Upadhyaya, a portfolio manager for Putnam Investments, adding this would likely bolster the dollar's value.

The minutes said "all members agreed that the FOMC statement ... should again indicate that policy accommodation could be removed at a pace that was likely to be measured," an indication the Fed likely would continue to raise rates in quarter percentage point increments.

Until now, the Fed has waited until after the following meeting to issue minutes, which market watchers say has limited their value as an insight into policy-makers' thinking while reducing their significance as a signaling device for the Fed.

OIL STILL HIGH

The minutes say that "a number of participants cited developments that could pose upside inflation risks."

Even though oil prices (CLc1) have moderated, they remain above levels in early 2004 and that, along with a cheaper dollar (=USD) , makes imports more costly, which could reduce competitive pressures on many industries.

One factor that has helped keep U.S. inflation low is a reluctance by companies to push prices up for fear of losing customers. So businesses have sought to keep profits up by trimming costs in other areas, but those savings are limited.

"A few participants also noted that uncertainty about the extent of resource slack in the economy was considerable and that it was possible the economy could soon be operating close to potential," the minutes said.

The minutes alluded to an increase in short-term rates on U.S. Treasury nominal and inflation-indexed securities as well, which the Fed worried "might be a warning sign that expectations were not as well anchored as they had been over the summer."

For all the concern, though, "participants generally expected that inflation would remain low in the foreseeable future."