Fed to stop raising short term interest rates

May 6, 2006

The Federal Reserve signaled that it will raise rates at next week's meeting to 5%, and then stop for a while. It will be the 16th consecutive quarter-point increase since the Fed began to return rates to normal from 1% in June 2004.

The Fed feels that it is safe to halt the hikes, since interest rates would be at a moderate level - neither too stimulating nor too constricting to the economy. Their criteria include:

• GDP growth, at 4.8% in Q1, appears to be slowing for Q2,
• Consumer spending was rising, despite higher gas prices,
• Business spending was also rising,
• Inflation held steady (excluding food and energy prices),
• Job market remained strong,
• Unemployment declined to only 4.75%,
• Housing construction eased - although it was higher than last year, it was lower than the peaks of last year, and was slowing.

They may consider a further rate increase in June or July if the economy in Q2 doesn’t slow as expected. They feel that the economy is operating at capacity, and is more in danger of inflation than recession. This position was reiterated by Chairman Bernanke at his presentation to the U.S. Congress Joint Economic Committee this past week.

What it Means:
Good news and bad news. The good news is that it means short term interest rates, like interest-only and variable-rate mortgages, will stop rising. It also means stable interest rates for business loans.

The bad news is that the dollar will start declining in value, since the Fed will not be supporting it with higher interest rates. Investors who hold the dollar will begin looking at other currencies that may offer higher interest rates, like the euro.

In fact, the dollar has already started its decline. The euro is at an 11-month high of more than $1.26, while the dollar is at a three month low of 113.70 against the yen. The dollar has been under increasing pressure following last weekend’s meeting of G7 finance ministers, which emphasized “global imbalances” and said currencies should reflect economic fundamentals. In response, China raised its key interest rate to 5.85%, its first hike for months.

Action Steps:
If you are planning foreign travel, go sooner rather than later - overseas prices will only go up.

Another way to protect yourself from a declining dollar is to have mutual funds focusing on countries whose currencies are going up - Canada, Europe and Japan. The profits from the companies will be in their currencies - which will be going up relative to the dollar. Net impact is a higher return for your portfolio.

Source:

Minutes of the Federal Reserve Open Market Committee

Testimony of Chairman Bernanke to U.S. Congress

Foreign Exchange Rates