In its regular interest rate policy meeting Tuesday, the Federal Reserve’s Open Market Committee agreed to leave the benchmark federal funds rate at a 46-year low of 1 percent.
But, amid signs of growing strength in the U.S. economy, the Fed signaled a shift toward rate hikes later this year by changing the wording of its outlook.
The committee formally abandoned its contention that deflation was a risk, preparing markets for the first rate rise in four years without specifying when higher borrowing costs may come.
While the key federal funds rate on overnight loans between banks remains unchanged , the Fed eliminated a reference to policy patience adopted in 2003, implying it may raise rates sooner rather than later to ward off potential inflation pressures.
However, it said rate rises would come at a "measured" pace.
The Fed's outlook took a more upbeat tone than prior meetings, saying the economy is "continuing to expand at a solid rate and hiring appears to have picked up." The comment on the labor market was also more optimistic than in March, when it expressed disappointment that new hiring has lagged.
In another change, Fed policy-makers made no mention of the threat of deflation and said that although inflation has moved higher, "long-term inflation expectations appear to have remained well contained."
While it’s not clear just when the Fed will begin tightening rates, the reasons for the policy shift are evident in recent economic data, including signs of higher inflation amid a solid expansion of production.
The government reported last week that gross domestic product, which measures the value of all goods and services produced within U.S. borders, grew at a steady 4.2 percent annual rate.
GDP performance over the nine months through March was the strongest in 20 years at an average annual rate of 5.5 percent a quarter.
Now, after 13 cuts since early 2001 — the last of them in June of last year — the Fed has signaled that it’s ready to begin pushing rates higher again.
"We have to recognize that maintaining the current level of the funds rate for too long will eventually result in an unwelcome increase in inflationary pressures," Fed Vice Chairman Roger Ferguson said in San Francisco a month ago.
The Fed has indicated it would not hesitate to raise rates even though there is a presidential election this November.
The Fed’s future moves will be heavily influenced by this Friday’s employment report, which is expected to show that the U.S economy created another 173,000 jobs in April after a surprisingly strong showing of 308,000 jobs created in March.
Prices have also started to gain, at least enough for Fed Chairman Alan Greenspan to be able to declare that deflation — the specter of a downward spiral in prices — is dead.
"Threats of deflation, which were a significant concern last year, by all indications, are no longer an issue for us," Greenspan told Congress two weeks ago in a comment taken by some as a "verbal tightening" of policy.
August is the month many analysts see as most likely for a rate rise, with one economist on a panel that shadows the Fed's activities saying the U.S. central bank must be mindful its actions take time to have the desired effect of tamping down pressures.
"With the acceleration in nominal spending growth, (firms) are now in the process of raising prices and with the acceleration in spending, those prices will stick and that is the inflationary process," Bank of America chief economist Mickey Levy said on Monday.
Levy is a member of the Shadow Open Market Committee, a group of seven senior economists who meet twice yearly to assess the Fed's policy action.
The group said a more appropriate or "neutral" rate — one that would control price rises but not depress business activity — likely was nearer 4 percent than the current 1 percent federal funds rate.