US Fed pauses rate hike cycle; keeps options open

09 August 2006

The US Federal Reserve has finally decided to end its two-year long policy of steady interest rate hikes. After hiking interest rates 17 consecutive times by 25 basis points each, which took the target Fed rate from as low as 1 per cent per annum in mid-2004 to 5.25 per cent currently, the US central bank has opted to keep key interest rates unchanged.

The Federal Open Market Committee (FOMC) of the Fed which met yesterday voted 9-1 in favour of the decision. The lone dissenting member voted for yet another hike of 25 basis points.

The pause was widely expected after data showing considerable slowdown in US economic growth. GDP growth for the second quarter declined considerably to 2.5 per cent per annum, much lower than the Jan-March quarter. Employment growth has also been disappointing over the last few months, indicating signs of weakening economic momentum.

US stock markets declined as the statement released by the Fed repeated its concerns over persisting inflationary pressures. "Readings on core inflation have been elevated in recent months, and the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures", the Fed said in the statement.

The Fed is clearly betting that slowing economic momentum will take care of inflation to a large extent. It also reckons that the full effect of past interest rate hikes have not reflected on inflation. "Inflation pressures seem likely to moderate over time, reflecting contained inflation expectations and the cumulative effects of monetary policy actions and other factors restraining aggregate demand", the statement said.

On the US economy the Fed said, "Economic growth has moderated from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices".