'Uncertain' Fed Hedged Bets

Minutes show that both a pause and a 50-basis-point hike were discussed at the May 10 meeting.
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Updated from 2:13 p.m. EDT

Fed

policymakers discussed everything from holding the fed funds rate steady to raising it by half a percentage point when last they met. Ultimately, however, conflicting signals on inflation led them to extend a two-year-old schedule of 25-basis-point hikes while communicating uncertainty about the future, minutes of the meeting show.

Mere mention of a 50-basis-point hike encouraged interest rate hawks. In the aftermath of Wednesdays' report, fed funds futures went from pricing in roughly even odds of a quarter-point hike in late June to a roughly 75% chance.

"Although the committee discussed policy approaches ranging from leaving the stance of policy unchanged at this meeting to increasing the federal funds rate 50 basis points, all members believed that an additional 25-basis-point firming of policy was appropriate today to keep inflation from rising and promote sustainable economic expansion," the minutes read.

"Given the risks to growth and inflation, committee members were uncertain about how much, if any, further tightening would be needed after today's action. In view of the risk that the outlook for inflation could worsen, the committee decided to repeat the indication in the policy statement released after the March meeting that some further policy firming could be required."

The May 10 meeting ended with the fed funds rate rising to 5% -- its 16th quarter-point increase in as many chances. In an accompanying policy statement, the Fed left the door open for either another hike or a pause when it next meets in late June.

"The committee judges that some further policy firming may yet be needed to address inflation risks, but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information," it said.

The remarks represented a moderately dovish revision to previous FOMC statements, adding "yet" and the phrase "will depend importantly on the evolution of the economic outlook." Still, the minutes showed, members wanted to remain noncommittal given the difficulty of assessing the economy.

"Core inflation recently had been a bit higher than had been expected, and several members remarked that core inflation was now around the upper end of what they viewed as an acceptable range," the minutes showed. "Moreover, a number of factors were augmenting the upside risks to inflation: the surge in energy and commodity prices, some recent weakness in the foreign exchange value of the dollar, and the possibility that the apparent increase in inflation expectations could, if it persisted, impart momentum to inflation.

In addition, the economy appeared to be operating at a relatively high level of resource utilization and had been growing quite strongly, and whether economic growth would moderate to a sustainable pace was not yet clear. At the same time, members also saw downside risks to economic activity."

Another debate surrounded how to characterize inflation expectations.

"Low and stable inflation expectations were key to the attainment of the committee's dual objectives of price stability and maximum sustainable economic growth," the minutes noted. "However, the apparent pickup in longer-term expectations, while worrisome, was relatively small. They remained within the range seen over the past couple of years, and the increase could well reverse before long. Accordingly, it appeared appropriate to characterize inflation expectations again as 'contained.'"

Taken as a whole, the Fed's May 10 commentary raised the possibility of a rate-hike pause later this month, although it didn't guarantee one. Hawkish arguments were strengthened on May 17 when the government said the core components of its consumer price index rose 0.3%, slightly more than expected. A subsequent gauge of inflation, last Friday's personal-income report, showed core inflation remains at the high end of the Fed's comfort zone, generally believed to be 2%.

Since the Fed made its May 10 pronouncement, the

Dow Jones Industrial Average

is down 559 points, or 4.8%, while the

S&P 500

has lost 56 points, or 4.2%. The

Nasdaq Composite

has fallen 159 points, or 6.8%.

The fed funds rate now sits at its highest level since April 2001. Policymakers began their current campaign of increases from a base of 1% on June 30, 2004, and they have steadily turned up the pressure as economic growth snapped back and signs of inflation crept in.

Under Chairman Ben Bernanke, who took over from Alan Greenspan on Jan. 31, the Fed has vowed to take a "data-dependent" approach to rate policy. The market has generally interpreted that as meaning the Fed would base future moves on the behavior of core inflation, which is currently running at roughly 2% a year.

The data-based stance has recently undergone modification. On April 27, Bernanke told Congress that the Fed would consider pausing rate hikes to let incoming data catch up with economic reality. A report later suggested Bernanke believed the markets misconstrued his remarks as guaranteeing a pause.