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The Federal Reserve, Taking It In Stride

Federal Reserve raises interest rates, but seems unworried about inflation and trade deficit


December 23, 2004
Copyright © 2004 CARIBBEAN BUSINESS. All Rights Reserved.

The Federal Reserve seemed to be preaching to the converted when it announced the fifth interest-rate increase in six months. No one was surprised by the announcement, which had been widely expected and accounted for in most financial institutions. The central bank’s monetary-policy committee voted unanimously to raise the federal-funds rate a quarter percentage point to 2.25%, the highest it has been in three years.

Financial institutions in Puerto Rico were prepared for the announcement and had made their projections for next year accordingly. Victor Galan, chairman & CEO of R-G Financial Corp., explained to CARIBBEAN BUSINESS that increased interest rates are likely to affect mortgage lending, not allowing them to perform as strongly as they did in 2001 and 2002. Yet, he was quick to point out that the industry will continue to grow in spite of interest rates, on account of the strong refinancing tendencies on the island. Bain Slack, vice president of equity research for Keefe, Bruyette, & Woods, confirmed Galan’s assessment. "U.S. investors may not expect the mortgage industry to continue growing on the island. However, the unique thing about Puerto Rico is that refinancing is driven by consolidation of personal debt rather than by interest rates," explained Slack, while predicting a good year for the mortgage industry.

The decision to increase interest rates was an optimistic statement on the part of the Federal Reserve. "Outlook appears to be growing at a moderate pace, despite the earlier increase in energy prices, and labor-market conditions continue to improve gradually," said the Federal Open Market Committee (FOMC). The committee also stated that even after the interest-rate increase, the stance of monetary policy remains accommodative and, is providing ongoing support to economic activity.

Some analysts believed the committee might have issued a wider increment in order to offset the debilitation of the dollar. On that point, the panel pointed out that, "Inflation and longer-term inflation expectations remain well-contained," meaning they can afford to be measured about the pace of rate increases over the next few months.

Yet, some are not so confident in this assessment, taking into account the fact that the dollar has dropped 25% since its peak in 2002.

The depreciation of the dollar has brought on serious consequences for the economy, even in ways that were not expected. Despite the weakened dollar, U.S trading partners showed little appetite for U.S. exports, causing a trade deficit that promises to hurt GDP estimates for the second half of 2004. The U.S. imported $55.46 billion more in goods and services than it exported in October, according to the Commerce Department. This is the widest monthly trade gap on record, and far wider than economists had expected. However, the Fed insists it is confident in its measured pace up to the moment.

Investors are expecting the Fed will raise the funds rate by a quarter percentage point at each of the next four FOMC meetings, which would put the rate at 3.25% by the end of June. However, in efforts to maintain the transparency he has promoted within the Federal Reserve, Greenspan is clear about the fact that the committee will react according to economic performance, not committing himself completely to the expected increments in the federal-funds rate throughout the coming year.

Surprises may yet be in store for the economy well after the Christmas season has come and gone. However, Joaquin Villamil, from Estudios Tecnicos, wouldn’t bet on any major shocks on the interest-rate front. "Interest rates will have to keep increasing to keep inflation and external balances in check," he said. As always, the world will be vigilant of Greenspan’s upcoming decisions, to see if the measured pace the Federal Reserve has adopted will be enough to allow everything to fall into the desired place.

This Caribbean Business article appears courtesy of Casiano Communications.
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