Federal Reserve Chairman Ben Bernanke and his colleagues raised short-term interest rates another quarter-percentage point Thursday for a 17th straight time, extending an unprecedented two-year campaign to keep a lid on inflation.
Yet stock prices surged, giving major indicators their biggest one-day gain in more than a year on a statement from the central bank that suggested — to some people, at least — that policy-makers might at last be nearing the end of the cycle.
After a two-day closed-door meeting, the Fed's policy-making Open Market Committee bumped up the benchmark overnight lending rate to 5.25 percent, its highest level in more than five years, saying rising energy costs and a growing economy "have the potential to sustain inflation pressures."
But the Fed also offered comments that were widely interpreted as more encouraging than harsher inflation rhetoric earlier this month from Bernanke and others that had roiled financial markets, sending stocks into a tailspin. The Dow Jones industrial average, which had been up about 80 points before the Fed announcement, ended with a gain or more than 217 points or 2 percent.
In its statement, issued with the afternoon rate decision, the Fed said the current economic slowdown "should help to limit inflation pressures over time." That would allow the Fed to step to the sidelines, perhaps as soon as its next meeting Aug. 8, ending a streak of consecutive quarter-point rate hikes dating back to June 30, 2004.
"The statement was much more encouraging or benign than anybody expected," said Hugh Johnson, chairman of Johnson Illington Advisors in Albany, N.Y. "It does imply that they may not raise interest rates further in August and September."
Investors also were relieved that the Fed did not get more aggressive and raise rates a half-percentage point as some traders had speculated it might in the days leading up to the announcement.
And investors, who have grown extremely jittery about the Fed and interest rates, were probably simply relieved to have the decision in hand, said Ethan Harris, chief U.S. economist at Lehman Bros.
"I get in a very good mood after I leave the dentist's office, and I think that's the feeling the stock market has today," he said.
The Fed's move immediately raises borrowing costs for businesses and consumers on a wide range of loans. Commercial banks quickly followed the Fed's decision by raising the prime rate a quarter-point to 8.25 percent, affecting the cost of borrowing on lines of credit and revolving accounts like credit cards.
When the Fed began raising rates under former Chairman Alan Greenspan exactly two years ago, the overnight benchmark stood at a 46-year low of 1 percent, and the initial quarter-point rate hikes had little perceptible effect. Credit was still easy, and mortgage rates actually drifted lower for months.
But as the Fed has continued its campaign, it has begun to bite, sending mortgage rates to their highest level in four years, for example. Many economists and market analysts have begun to call for the Fed to take a break for a meeting or two and assess whether further rate hikes are really needed.
Although the economy surged in a post-Katrina rebound in the first quarter of this year, economists say it has slowed substantially since then and is likely to slow more over the next six to nine months, raising the prospect that the Fed could raise rates too high, choking off growth. The economy added a paltry 75,000 jobs in May and the booming housing market is showing clear signs of a slowdown, partly in response to the Fed's steady squeezing of credit.
But at the same time consumer prices, fueled by surging gas costs, are rising at a 4 percent annual rate and appear to be accelerating. Even excluding the volatile food and energy categories, which Fed policy-makers do to look at underlying trends, prices are rising at a 2.4 percent annual rate, well above the Fed's upper target of 2 percent.
So the Fed's relatively moderate language was welcomed by analysts who are hoping are calling for a pause in the rate-hike campaign.
"This suggests or implies that the Fed may not make that age-old mistake of raising interest rates too high," Johnson said.
Nevertheless, some analysts said financial markets might have overreacted to language in the Fed statement that was in fact somewhat ambiguous, leaving the Fed plenty of room to maneuver depending on what inflation figures and other economic data are reported over the next six weeks until the next policy-setting session.
"The odds of a pause in August are slightly higher after this language but in truth the Fed picture hasn’t really changed," Harris said. The Fed still faces the dilemma of an environment in which growth is slowing while inflation is accelerating.
Central bankers might be hopeful that inflation naturally dissipates, but "it doesn’t happen that fast," Harris said. "It takes a long time to push inflation out of the system."
Full text of Fed statement
Following is the full text of the Fed's statement announcing Thursday's rate change:
The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 5-1/4 percent.
Recent indicators suggest that economic growth is moderating from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.
Readings on core inflation have been elevated in recent months. Ongoing productivity gains have held down the rise in unit labor costs, and inflation expectations remain contained. However, the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures.
Although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Jack Guynn; Donald L. Kohn; Randall S. Kroszner; Jeffrey M. Lacker; Sandra Pianalto; Kevin M. Warsh; and Janet L. Yellen.
In a related action, the Board of Governors unanimously approved a 25-basis-point increase in the discount rate to 6-1/4 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 and Dallas.