Once again, Federal Reserve Chairman Alan Greenspan and his Board of Governors raised the Federal Funds Rate to 3.50 percent, up from a 40 year low of one percent in mid-2003. The Federal Funds rate is the rate that banks charge each other for overnight funds, and, contrary to much popular thinking, does not necessarily have a direct affect on long term mortgage rates. In fact, the yield on the ten year treasury bill, which affects fixed rate mortgages, rallied slightly on the news.

The Fed has made staving off inflation a priority for at least ten years. The monetary policy strives to strike a balance between healthy growth and stable prices. The assumption is this: Robust growth creates price inflation. The Fed raises short term rates to cool off the economy as a pre-emptive strike to inflation. Alternatively, the Fed can lower rates to spur economic growth, as it did in the aftermath of the 9/11 attacks.

But the press release accompanied by the move seemed to me to be a bit ambiguous. Let's take a look at a couple of statements.

"… the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity."

Here's how to interpret that sentence: "Current monetary policy and increasing productivity supports current economic activity."

Well, gains in productivity certainly might support economic activity but I'm not sure a monetary policy of tightening credit (raising rates) helps. I thought raising rates, often termed, "tapping on the brakes," is supposed to curtail economic activity in order to keep inflation in check.

Here's another one:

"Core inflation has been relatively low in recent months and longer-term inflation expectations remain well-contained, but pressures on inflation have stayed elevated."

It sounds like the Fed is saying this: "There's no inflation now and we don't expect inflation to be a problem in the future, but we're still worried about inflation." My guess is that the Fed is concerned about the "non-core" inflation, such as skyrocketing real estate and energy prices, which should surely be a real concern.

And last:

"With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability."

My translation: "We don't really need to raise rates because inflation is contained and we may change our policy at any time."

In the previous rate increases, the Fed's language was similar. Their intent is to continue to raise rates but remain flexible if economic conditions change.

My take on this? I think the Fed is keeping one thing a secret. Core inflation, indeed, has been well contained and the economy, although productive and relatively strong, isn't on fire. I think the Fed decided it needed to raise the Federal Funds rate in order to make some room to lower rates again when necessary in the future. There's not a whole lot of room to go lower when you're at one percent.

Published: August 10, 2005

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, the president of PMC Mortgage Corporation in Alexandria, VA, is a mortgage columnist whose work has appeared in numerous consumer, real estate, and mortgage publications. Mr. Savage welcomes your questions for possible use in this column, however because of the volume of mail received, Mr. Savage cannot answer questions individually.