By Martin Wolk Executive business editor
updated 8/10/2004 3:54:40 PM ET 2004-08-10T19:54:40

The Federal Reserve Tuesday raised a key interest rate for the second time this year, saying the economy "appears poised to resume a stronger pace of expansion" despite recent evidence of a slowdown.

The central bank hiked the overnight federal funds rate a quarter-point to 1.5 percent, slightly increasing borrowing costs for many businesses and consumers. The move, which had been widely anticipated, came despite Friday’s startling report that the economy created just 32,000 jobs in July, far short of the 220,000 or so that forecasters were expecting. It was the second straight month of weak job growth and raised the possibility that what Fed Chairman Alan Greenspan has described as an economic “soft spot” is lasting longer than anticipated.

In a statement announcing the rate hike Tuesday, the Fed said the recent slowdown probably is due largely to a sharp increase in energy prices. But the Fed's upbeat view that growth is about to accelerate again led many analysts to conclude that the central bank is likely to increase rates by another quarter-point at its next meeting of policy-makers Sept. 21.

"It looks like they just see this as kind of a passing shower, and everything will be back on track by fall," said John Bitner, chief economist at Eastern Bank in Boston.

After Friday's disappointing employment report, many analysts speculated that the Fed would stay on hold at its next meeting, especially if the August employment report shows continued weakness. But Tuesday's statement appeared to reinforce the view that Fed officials prefer to continue raising rates in a "measured" fashion, as Greenspan and others have said frequently.

In a reflection of a widespread feeling that rates need to be pushed higher, the increase in the funds rate was approved unanimously by 12-members Federal Open Market Committee, and a related increase in the discount rate was approved at the request of all 12 regional Fed banks.

Bond prices fell, pushing market interest rates higher as traders bet that the Fed indeed will raise rates again next month. Futures prices indicate traders now believe there is a 78 percent chance the Fed will raise rates a quarter-point next month, up from 50 percent before Tuesday's announcement, said Mary Ann Hurley, a trader with D.A. Davidson & Co. Stock prices, which lost more than 3 percent last week, were sharply higher, possibly reflecting the Fed's view that the economy's problems are temporary.

Despite the weak employment figures, most analysts believe the economy is in relatively good shape based on a range of other indicators including rising business and consumer confidence and early evidence of stronger retail sales in July. But sustained high oil prices and the lack of job growth mean analysts and Fed policy-makers will have to pay close attention to economic indicators in coming weeks.

"We don’t seem to have the clear path that many of us might have thought the Fed was on two or three months ago," said John Silvia, chief economist at Wachovia Securities. "We're going to go from meeting to meeting, it appears, until we see what is the impact of oil prices  and until labor market turns around."

While the Fed usually raises rates to prevent the economy from overheating, the current cycle is unusual because economic growth appears to have peaked in the second half of last year. But Greenspan and other Fed officials say the central bank needs to remove the "accommodation" it created by aggressively lowering rates over the past several years.

The central bank lowered rates 13 times from January 2001 through June 2003, bringing the benchmark overnight rate to its lowest level in 46 years in an effort to stimulate the economy after the end of the nation’s longest postwar expansion. At the end of the cycle the Fed continued to cut rates to prevent the remote but potentially devastating outbreak of deflation, which now appears to have passed.

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Because the employment report came out so soon before Tuesday’s meeting of Greenspan and fellow policy-makers, the Fed had little choice but to follow through on its previously stated plan to continue with a “measured” series of rate hikes, analysts said. Anything else could have spooked financial markets by giving the impression the Fed was worried about the possibility of a further slowdown. The Fed reiterated Tuesday that it expects to continue a "measured" pace or rate hikes but added that it "will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability."

Complete text of Fed statement
"The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 1-1/2 percent.

The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. In recent months, output growth has moderated and the pace of improvement in labor market conditions has slowed. This softness likely owes importantly to the substantial rise in energy prices. The economy nevertheless appears poised to resume a stronger pace of expansion going forward. Inflation has been somewhat elevated this year, though a portion of the rise in prices seems to reflect transitory factors.

The Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters are roughly equal. With underlying inflation still expected to be relatively low, 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.

Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Timothy F. Geithner, Vice Chairman; Ben S. Bernanke; Susan S. Bies; Roger W. Ferguson, Jr.; Edward M. Gramlich; Thomas M. Hoenig; Donald L. Kohn; Cathy E. Minehan; Mark W. Olson; Sandra Pianalto; and William Poole.

In a related action, the Board of Governors unanimously approved a 25 basis point increase in the discount rate to 2-1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco."

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