While most investors had expected several more interest rate hikes this year, confirmation from the Federal Reserve came as an unwelcome surprise Tuesday. In the minutes of the Fed's Dec. 14 committee meeting, central bank officials said short-term rates are too low at 2.25% and that inflation could become a problem unless further action is taken. "The FOMC minutes for the December meeting were considerably more hawkish than generally expected," said Stephen Stanley, an economist at RBS Greenwich Capital. "The committee has clearly become much more confident in the sustainability of the expansion." The stock market slipped deeper into negative territory in the wake of the news and bonds sold off. The Dow Jones Industrial Average lost 96 points to 10,631 on the session, while the Nasdaq Composite slide 44 points to 2108. Treasury bond yields rose to 4.28%. The Fed has been saying since last May that it would raise rates "at a pace that is likely to be measured" and economists have predicted that the Fed funds rate will rise to between 3.25% and 3.5% by the end of 2005. Yet the minutes of the December meeting were greeted with some concern. "There is nothing in the FOMC minutes to suggest the Fed is thinking of slowing the pace of tightening in response to the incoming data," said Ian Shepherdson, chief economist at High Frequency Economics. "Indeed the tone of these minutes is notably more hawkish than in November." The Fed said the economic expansion is now "more firmly entrenched," and that cost and price pressures could become a "clearer intermediate-term risk to sustained good economic performance" absent further rate hikes. "The current level of the real funds rate target remains below the level it most likely would need to reach to keep inflation stable and output at its potential," the committee said.
Policy members cited the drop in the dollar, slower productivity growth and high energy prices as factors that could boost inflation going forward. Some participants also said there is considerable uncertainty about the extent of resource slack in the economy and that it was possible the economy could soon be operating close to potential. "This seems extreme to us but, together with other members' fears that loose policy is encouraging "excessive risk-taking," it is clear the Fed is set on higher rates," Shepherdson said. Some Fed officials said they were worried that the prolonged period of low rates had contributed to risk-taking in financial markets, citing narrow credit spreads, an increase in initial public offerings and an upturn in merger and acquisition activity. The committee believes that labor market conditions are "gradually improving" despite November's weak report. But a number of participants voiced concerns about domestic and global financial imbalances, saying the chances of significantly reducing the federal and current account deficits are "remote." In its last policy statement, the Fed said the upside and downside risks to growth and inflation were "roughly equal," adding that it would "respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability." The Fed released the minutes just three weeks after its last meeting, instead of the usual six. The decision to expedite the release of the minutes was announced at the December meeting.