US rates on hold - what next?

The US Fed has decided to keep interest rates unchanged at 5.25%, but remains wary of inflationary risks to the economy. The decision to keep the rates on hold for the third consecutive month after a series of 17 successive hikes over past two years is on the expected lines. As before, Richmond Fed President Lacker was the lone dissenting member of FOMC favouring a quarter percentage point rise hike.

The Fed observed that economic growth has slowed over the course of the year, but going forward, the economy is expected to expand at a moderate pace. While recognizing that inflation pressures are likely to moderate over time, the FOMC continues to emphasise that “… some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”

The Fed's current 'watch and wait' policy on rates follows signs that price pressures are easing and that the economy has slowed since the start of the year. There has been perceptible easing of price pressures owing to lower energy prices, contained inflation expectations, cumulative effects of past monetary policy actions and other factors restraining aggregate demand, though the Fed does not want to let the guard down. On the other hand, there has been a noticeable output drop in the second quarter and the once-buoyant housing market has cooled considerably. The challenge before the Fed Policymakers is to control inflation while ensuring that the slowdown in economic activity does not worsen into a prolonged downturn.

The Fed's decision to keep its policy options open has left the market guessing on the future course of interest rates. Although it is widely believed that Fed will keep interest rates steady in the near future, the market is divided on the likely Fed action in 2007. On the one hand, as the Fed continues to warn on inflation risks, rate hikes may be required in future. On the other hand, there is a section of the market that believes that continued economic slowdown and weakness in the housing market may force the Fed to reverse the cycle and start cutting the rates sometime in second half of 2007.