The Federal Reserve began its much anticipated belt-tightening effort last week by ratcheting up its target for short-term interest rates for the first time in four years.

As widely expected, the Fed, in a unanimous vote, raised its short-term lending rate to 1.25% from a 46-year low of 1%. In a statement, the Fed made known its plans to continue to push rates higher "at a pace that is likely to be measured." In other words, the Fed intends to raise rates in increments of 25 basis points.

However, the Fed governors managed to temper that conservative sentiment with a stipulation that the central bank will "respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability." Essentially, the Federal Reserve is giving itself some wiggle room to increase rates by a wider margin if the pace of inflation quickens.

The move came and went without much fanfare because the Federal Open Market Committee (FOMC), the Fed's policymaking arm, has been tipping its hand the last few months by communicating its intentions to adopt a more restrictive stance on rates. Given the likelihood that the rate hike was already priced in, the major stock indices had little reaction to the news.

The nation's chief lender said its approach to monetary policy will remain accommodative for the time being and that "robust underlying growth" in productivity will provide ongoing support for economic activity. In the period between this meeting and its previous meeting, evidence gathered shows that output is continuing to expand at a solid pace and that labor market conditions have made some strides. Still, the Fed noted that incoming inflation data is "somewhat elevated," a trend that appears to have been fueled in recent months by "transitory factors" such as higher energy and commodity prices.

"For the Fed to view a potential structural inflation problem, you would need to see them view labor markets as being significantly tighter than they are now [and] more evidence of escalating pressures on wages," said Keith Hembre, chief economist at US Bancorp Asset Management. He noted that labor costs comprise roughly two-thirds of the nation's total cost of business. Based on the productivity gains that have occurred in recent years and the expectation that they'll remain somewhat elevated relative to pre-1995, the overall unit labor cost outlook on an intermediate term basis is relatively favorable, he said. That is what the Fed will be keying in on when evaluating inflation, Hembre said.

"If the economy follows the expected path of the Fed, which is for 4% or a little stronger growth and core inflation measures to remain in the 1.5% to 2% range, then they'll be slow to tighten, but they will continue to tighten," Hembre said. "At that pace, we should see the economic slack in the economy diminish over time. That will color the pace at which the Fed tightens. The inflation numbers in the second half should look better than they did in the first half. But if the inflation numbers come in higher, they're going to be more aggressive."

"What they told the market on Wednesday was that they're not really in any big hurry to raise rates and that no alarm bells were ringing because of overt concerns surrounding the inflation outlook," said David Rosenberg, chief economist for North America at Merrill Lynch. "But the Fed kept an open mind in that if the data moves against them, they'll be more aggressive. The base case is that the inflation backdrop is just fine. Greenspan gradualism will remain intact," Rosenberg added.

In a recent Merrill survey, equity fund managers, on average, said that the Fed would be back to neutral when the target rate is back at 3%. More than 70% of the managers said a neutral stance would require a Fed Funds rate of 3% or higher. Merrill noted that fund managers' sentiment towards growth remains soft. "What is slightly alarming is that this hawkish view on interest rates is being espoused at a time when global growth expectations remain relatively weak," wrote David Bowers, chief investment strategist at Merrill.

More than a third of the respondents believe that the outlook for corporate profits will deteriorate, with the mean expectation for earnings growth weakening to a meager 9%, according to the report. "So, on the one hand, fund managers are expressing concern about the momentum of the global economy, while on the other, they are worried about inflation and believe the Fed has to tighten monetary policy considerably before these inflation concerns are curtailed," Bowers wrote. Having said that, he noted that it is perhaps not surprising that asset allocations among portfolio managers remain overweight cash, underweight bonds and less overweight stocks than they were a few months ago.

Meanwhile, a recent op-ed piece in Barron's argued that active fund managers, as a group, haven't kept up with the index return, which could lead to harsh halftime pep talks by their bosses and more aggressive tactics in the second half. If that is the case, one can expect to see portfolio managers trying to shoot the moon in hopes of garnering fatter returns for investors.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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