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Interest Rates: Look, Ma, No Pause!

After teasing Wall Street with his utterances in the last two weeks, Federal Reserve Chairman Ben S. Bernanke managed not to spring a big surprise at the central bank's May 10 meeting. As widely expected, the Federal Open Market Committee raised interest rates for the 16th time in a row since June, 2004, to 5%. And the panel carved out some wiggle room to continue raising rates or pause in the future. "They opened the door for stop-and-go Fed policy," says Diane Swonk, chief economist at Mesirow Financial in Chicago.

Accomplishing this balancing act has been tricky. Only three months into the job, Bernanke is operating at a delicate time, when the Fed has to determine when and how to ease up on its long rate-raising march. Wall Street, accustomed to lockstep rate increases, has been on edge over the transition. And that has made Bernanke's campaign to improve communications with investors and the public all the more difficult.

Wall Street cheered when Bernanke indicated at his Apr. 27 testimony on Capitol Hill that a pause in rate hikes may be in the cards. But he then sent investors into a funk five days later when CNBC anchor Maria Bartiromo (a regular BusinessWeek columnist) reported that the chairman told her the markets had misread him.

UNCLEAR REACTION. Now Bernanke may have finally gotten the message across that the Fed may pause, but not stop rate hikes altogether, over the course of this year. In the statement released after the FOMC meeting, the panel said: "The Committee judges that some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information."

The stock market was volatile following the announcement, but did not show a clearly positive or negative reaction by the close. Meanwhile, bond yields jumped after the news but settled with small gains, leaving the 10-year note at 5.12%.

Many Fed watchers are no longer sure that the next FOMC meeting on June 28 will be the day when the central bank finally hits the pause button. Not even the Fed is certain. Economic data show conflicting signals. Inflation is edging up slightly, and Morgan Stanley (MS) projects that core consumer prices -- excluding oil and food prices -- will rise to 2.7% by yearend. That's higher than the 1% to 2% inflation range that Bernanke has identified as his comfort zone.

LARGER UNCERTAINTY. At the same time, the FOMC expects that the 16 rate hikes will start putting the brakes on the economy this year. They stated after the latest meeting: "Growth [is] likely to moderate to a more sustainable pace, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices."

Bernanke is likely to keep Wall Street guessing over the Fed's next moves. But if the Fed Chairman manages to relay his message clearly, investors will chalk it up to uncertainty hanging over the economy and not over Bernanke's words.

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