Washington, Jan. 28--The Federal Reserve has freed its hands for a future increase in interest rates.
The central bank left its short-term interest rate target at a 45-year low of 1%. But the bigger action was in its language, which it uses in addition to rate changes to guide the markets and economy. In an important tactical move, its policy panel dropped the commitment it first made five months ago to keep interest rates low for "a considerable period."
Instead, the Federal Open Market Committee said after its first two-day meeting of this year that it can be "patient" in raising rates because inflation is low and the economy still hasn't fully recovered.
Investors interpreted the omission of "considerable period" as a signal that the Fed is closer to raising interest rates than many thought. The 10-year Treasury bond yield leapt to 4.17% from 4.08% Tuesday. Futures trading on the Chicago Board of Trade suggests traders have moved up the month when they think the Fed will start raising rates to June from August.
The prospect of higher interest rates damped the relative attraction of stocks, which compete with interest-bearing investments. The Dow Jones Industrial Average, up almost 50 points earlier in the day, plunged after the Fed's announcement, closing down 141.55 points at 10468.37. The dollar rallied against the euro, since higher rates would improve the return on dollar-denominated loans.
The announcement doesn't seem to suggest an interest rate increase is imminent. Rather, it appears the central bank wants the freedom to raise rates if the economy continues to improve, without worrying about violating a perceived commitment to keep them down.
"This is tactical," said Richard Berner, chief U.S. economist at Morgan Stanley. "It serves as a reminder that monetary policy will not stay on hold forever."
The rest of the statement suggested the Fed's economic outlook hasn't changed significantly since it last met in early December. "Output is expanding briskly," it said. While "new hiring remains subdued, other indicators suggest an improvement in the labor market."
Meanwhile, excluding food and energy prices, inflation is "muted and expected to remain low." It said upside and downside risks to economic growth were "roughly equal," while the risk of "an unwelcome fall in inflation" was "almost equal" to the risk of an increase.
Economic reports Wednesday suggested the expansion may have slowed in December though it doesn't appear to be in trouble. New-home sales fell 5.1% in December from November to a seasonally adjusted annual rate of 1.06 million units, while new orders for durable goods -- those meant to last at least three years -- were unchanged in December from November.
Fed officials feel underlying inflation, at about 1%, is already at the bottom of their preferred range, and with businesses operating with a lot of spare capacity and unemployment high, there is little prospect that inflation will rise from that level. Still, in recent months they have grown more confident that the economic expansion is unfolding as expected.
Some officials think upward pressure on consumer prices and wages could develop before the end of 2005, and they would like to start raising rates "well in advance of that point, rather than slamming on the brakes in the middle of 2005," said Michael Prell, an economic consultant in Arlington, Va. "This gets the market into better alignment with their thinking."
The FOMC, made up of seven governors in Washington and 12 regional bank presidents, of whom five vote, agreed unanimously to leave the federal-funds rate at 1%. The rate, charged on overnight loans between banks, has stood there since last June after 13 successive cuts beginning in January 2001.
With its shift in language, the Fed has exited from an unusual experiment with verbal monetary policy born of last year's brush with deflation, or generally falling prices.
