Inflation Concerns Prompt New Fed Rate Hike

Nov. 1, 2005 — -- The Federal Reserve's Open Market Committee (FOMC) met today and voted to increase a key interest rate by a quarter-point, to 4 percent. This is the 12th rate increase since June 2004 and brings the "fed funds" rate to its highest point since June 2001.

The Fed has been fairly consistent in keeping a "measured pace" of rate hikes. The FOMC "tightens" monetary policy to keep inflation in check by slowing consumer demand.

The post-meeting policy statement remains mostly the same, but did address the run-up in energy prices which occurred after the recent hurricanes disrupted domestic oil production and refining operations in the Gulf of Mexico region.

"The cumulative rise in energy and other costs have the potential to add to inflation pressures," said the statement. "However, core inflation has been relatively low in recent months and longer-term inflation expectations remain contained."

The governors meet again on Dec. 13 for the final meeting of the year. Most economists expect they'll hike rates again next month.

What does this mean? Inflation has become a real concern as energy prices have increased in the past year. Even without the increasing cost of oil, prices are up about 2 percent according to the latest government figures. This is at the top of the Fed's "comfort zone" for price growth.

Hiking interest rates tends to slow price growth. Why? When you increase interest rates it becomes more expensive to borrow money for major purchases. Businesses and consumers tend to delay big purchases, slowing demand and reducing the pressure to increase prices.

The opposite is also true. Reducing rates heats up demand and can keep the economy growing through tough times. After the Sept. 11 attacks the Fed quickly dropped rates to historic lows to bring the economy quickly out of a recession.

How much does this matter? This is important. Many short-term credit vehicles (like credit cards and home equity lines of credit) are directly affected by the fed funds rate. Prime rate, a measure many consumers are familiar with, is exactly 3 percent above the rate changed by the FOMC today. Many "big-ticket" credit facilities (such as mortgage rates and student loans) will not be directly affected by today's decision, but tend to move in the same direction as the fed funds rate.

A good rule of thumb: Short-term or revolving credit will go up when the Fed hikes rates, while long-term credit vehicles tend to move in the same direction but at a slower pace. 

Definition: The federal funds rate is the interest rate charged for overnight loans between banks.

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