The Federal Reserve raised short-term interest for an 11th straight time Tuesday, saying the after-effects of Hurricane Katrina have increased near-term economic uncertainty but "do not pose a more persistent threat."
Policy-makers led by Fed Chairman Alan Greenspan raised the benchmark overnight lending rate by a quarter-percentage point to 3.75 percent, its highest level in more than four years.
Although the move was expected, stock prices fell sharply as many investors were disappointed the Fed indicated more rate hikes are likely, using language virtually unchanged from recent past statements. Many Wall Street traders had hoped the Fed would use Katrina as an excuse to remove or change the language, but instead the central bank reiterated its long-standing position that "policy accommodation can be removed at a pace that is likely to be measured."
The Dow Jones industrial average, which had been in positive territory before the Fed's rate announcement late in the session, fell 77 points or 0.7 percent to close at 10,482.
Diane Swonk, chief economist for Mesirow Financial in Chicago, said the Fed statement was "a bit more hawkish" than she would have expected, especially with Hurricane Rita heading into the Gulf of Mexico, once again roiling energy markets.
"Once they got the uncertainty of Katrina out of the way they just got back to their boilerplate statement," Swonk said.
Under the direction of Greenspan, the Fed’s policy-making Open Market Committee has raised short-term rates a quarter-point at every scheduled meeting since June 30, 2004, when the overnight federal funds rate stood at a 46-year low of 1 percent.
While most of the rate hikes have been approved by a unanimous vote of the 10-member panel, Tuesday's move was opposed by Fed Gov. Mark Olson, who preferred to leave rates unchanged. Swonk said the rare opposition by a Fed governor was a sign of likely intense debate over the long-term impact of Katrina.
Central bankers apparently are more concerned that soaring energy costs left in Katrina’s wake will lead to higher inflation rather than cause a lasting economic slowdown. Most forecasters believe the dampening effect of Katrina will be temporary and offset next year by a boost from the massive federal and private spending needed to rebuild devastated New Orleans and other Gulf Coast cities.
In a statement announcing the rate decision, the Fed said the "widespread devastation in the Gulf region" and resulting boost in energy prices will slow spending, production and employment. The Fed added that "higher energy and other costs have the potential to add to inflation pressures" but noted that core inflation has been muted in recent months.
Ethan Harris, chief U.S. economist for Lehman Bros., said it should not be surprising the Fed chose to focus on the potential inflationary effects of Katrina, especially with Congress poised to spend up to $200 billion on recovery from the storm and rebuilding the devastated region.
"I actually think the inflation risk is greater than the growth risk," said Harris. "There are risks on both sides. But I think given the scale of the fiscal package, you're more likely to get increased growth than less growth by year-end."
Others disagree. Wachovia Securities economist Gina Martin said higher energy prices are likely to slow consumer spending "pretty significantly" in the fourth quarter and into early next year.
"I think the effect is more slower growth than higher inflation," she said. "The Fed sees it a little bit differently."
Swonk said central bankers might have concluded that raising rates now was more palatable than it will be at their next meeting Nov. 1, when much of the short-term impact of Katrina will be evident in economic data. Unemployment is likely to rise in wake of the massive displacement caused by the storm, and industrial output likely will fall.
"It's easier to say Katrina is a transitory effect when you haven't seen the data yet then when you're in the middle of bad data," she said.
But Richard Yamarone, director of economic research at Argus Research, said the fed's statement "essentially locks in additional rate hikes" at the Nov. 1 and Dec. 13 meetings of policy-makers.
With the economy expanding steadily at a rate near its long-term average of 3.5 percent — and Greenspan rapidly running out of time in his 18-year term as Fed chief — the central bank is slowly tightening credit to prevent any overheating that could lead to accelerating inflation.
Greenspan and other Fed officials also have raised concern about rapid growth in home prices, which have been buoyed by near-record low mortgage rates. Housing starts edged lower in August for a second straight month, the government said Tuesday, in a sign the market may be cooling slightly at last.
In a speech last month looking back at his 18 years as Fed chief, Greenspan warned that "history has not dealt kindly" with the aftermath of asset price bubbles.
Greenspan is scheduled to chair only three more meetings of the Federal Open Market Committee before he steps down Jan. 31, when his term as a Fed governor ends. He is not eligible for reappointment, and the Fed indicated this month that he has no plans to stay on.
President Bush has not yet named a successor.
