The Federal Reserve raised key short-term interest rates Wednesday for the first time in more than four years, launching a risky campaign to suppress inflation without stamping out economic growth.
Concluding a two-day meeting, Fed Chairman Alan Greenspan and fellow central bank policy-makers boosted the benchmark federal funds rate a quarter-point to 1.25 percent, citing recent evidence the economy “is continuing to expand at a solid pace.” The move, which is expected to be the first of a many over the next year or more, affects a wide range of consumer and business loans.
The federal funds rate is what banks charge each other for overnight loans and last changed in June 2003, when the Fed lowered it to 1 percent, a level not seen since 1958. The last time the Fed raised rates was in May 2000, shortly after the stock market peaked.
Major turning point in Fed policy
The rate hike, which had been widely expected, marks a major turning point in Fed policy, ending a long cycle of easing that began in January 2001, just as the economy was about to plunge into its first recession in 10 years. Even after the recession ended in November 2001, the Fed continued lowering rates as the economy struggled through a series of challenges, including uncertainty related to the U.S. war on Iraq.
"The simple fact is that the Fed was reacting to a series of crises that hit the economy," said Joel Naroff of Naroff Economic Advisors. He cited the terrorist attacks of Sept. 11, 2001, the collapse of the dot-com bubble and a series of corporate accounting scandals in addition to the Iraq war. "What we have is an artificially low (interest rate) level that was created because of crises."
While the economy does not seem in any imminent danger of overheating, nearly 1 million jobs have been added to payrolls over the past three months, ending a long jobless recovery and signaling that the economy has resumed a robust, sustainable expansion, analysts say.
And consumer inflation suddenly has picked up speed this year, forcing Fed policy-makers to renew their vigilance about rising prices. Even excluding the volatile food and energy categories, consumer prices in May were up 1.7 percent over year-earlier levels, compared with 1.1 percent as recently as January.
"We’re seeing the inflation rate starting to creep up," said David Wyss, chief economist at Standard & Poor’s. "It’s not dangerous yet, but the Fed wants to nip it in the bud, and I think they’re right. They have to keep stomping on the lid."
Financial markets took the Fed rate hike in stride, with stock prices edging higher. The Dow Jones industrial average, which was down about 20 points before the Fed’s afternoon announcement, ended up 22 points or 0.2 percent.
“You couldn’t have asked for a more tightly scripted Fed decision," said Mark Zandi, chief economist of Economy.com, a forecasting firm. “They didn’t deviate at all.”
In a statement accompanying the rate-hike announcement, the Fed reiterated it planned to raise rates at a “measured” pace, saying the recent surge in inflation appears to be “transitory.” But echoing recent comments from Greenspan and other central bankers, the central bank also said it would “respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”
Drew Matus, an economist at Lehman Bros., called the Fed’s position a “gamble” that will force financial markets to focus on any signs of inflation, including Thursday’s closely watched survey of purchasing managers and Friday's monthly employment report.
Mortgage rates moving up
Long-term mortgage rates already have responded to the anticipated Fed rate-hike cycle and rising inflation. A typical 30-year, fixed-rate mortgage now carries a 6.25 percent rate, up from 5.4 percent in March. Rates could rise to 7.5 or even 8 percent over the next 18 months said Naroff, who estimates the Fed ultimately will push up the federal funds rate to 4 percent, somewhat higher than other forecasters project.
Variable-rate loans, such as home equity lines, short-term business credit and even credit card rates could respond quickly to the Fed move. Major banks announced Wednesday that the prime rate, a benchmark for many business and consumer loans, would rise a quarter-point to 4.25 percent, matching the Fed increase.
Greenspan and other central bankers have spoken frequently of their plan to raise rates in a "measured" fashion, although they also have warned that they will do what is needed to prevent inflation from getting beyond their target level. Analysts say the risk is that the Fed could raise rates too far and too fast, causing a sharp slowdown in key economic sectors like housing and auto sales.
Only a few months ago, many Wall Street economists expected the Fed would leave rates on hold until 2005. Now most analysts expect the central bank to raise rates at least two or three more times this year.
Text of Fed statement
The following is the full statement released by the Fed Wednesday:
"Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 1-1/4 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. The evidence accumulated over the intermeeting period indicates that output is continuing to expand at a solid pace and labor market conditions have improved. Although incoming inflation data are somewhat elevated, a portion of the increase in recent months appears to have been due to 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 approved a 25 basis point increase in the discount rate to 2-1/4 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."