As everyone expected, the Fed increased its target for the federal funds rate. In the statement, they suggested that the economy is close to capacity, but that aggregate demand is slowing down. They also did not commit themselves to raising the rate again, though they clearly said that they would if conditions warrant. So far, financial markets are reacting positively to the accompanying statement.
So will the Fed keep going? The federal funds futures contracts seem to indicate one more increase, up to 5.5%. The overall economy is still strong and inflation is higher than the Fed seems comfortable with. However, there are two factors that are helping to slow down the economy. First, high energy prices will tend to moderate economic growth. As long as the Fed does not pursue an accommodative policy, any inflation from higher energy prices is self-limiting. Second, other central banks are tightening policy, which may work to slow down the rest of the world’s economy.
Bottom line: The Fed has outside help. The trick is to know when to stop. As has been pointed out in the press, the Fed has a history of overdoing tightening regimes. To demonstrate his inflation-fighting credentials, Bernanke may continue this pattern. Short term, that is negative for stocks and the economy. Long term, it will help keep inflation expectations contained, which is good for stocks and the economy.