Higher Rate Doesn't Mean Much Higher

Raising interest rates tends to rein in household and business spending, which helps restrain inflation in a roaring economy; lowering rates encourages spending, which helps boost a weak economy. The Fed raised the funds rate to as high as 6.5 percent in 2000, at the peak of the recent boom, but started reducing them in early 2001 as the economy slid into recession.

The Fed kept lowering its target through the recession and the during the financial turmoil after the Sept. 11, 2001, terrorist attacks. The Fed cut rates repeatedly through the sometimes halting economic recovery, which appeared inhibited at times by anxieties over corporate scandals and the war in Iraq.

Finally, a year ago, Fed officials lowered their target to 1 percent, both to keep spurring growth and to prevent falling inflation from giving way to deflation, a dangerous drop in overall prices. Interest rates plunged throughout the economy. The average 30-year-fixed rate mortgage, for example, fell to 5.24 percent last June.

Greenspan has recently characterized the current low rate as "increasingly unnecessary" now that economic expansion appears likely to continue at a steady, healthy pace. His comments and those of his Fed colleagues about the need to start raising the rate caused other rates to rise. The average rate on a 30-year-fixed mortgage reached 6.25 percent last week, according to mortgage financier Freddie Mac.

One key reason the Fed has been able to hold rates so low is that inflation is so tame, around 2 percent, depending on the measure. Most economists believe that largely represents the success of the Fed's quarter-century campaign to bring inflation down from the double-digit levels of the 1970s.

Fed officials have vowed not to squander that achievement by letting inflation get out of control again. If they succeed, inflation should remain low, which means interest rates would be more likely to stay relatively low as well.

But because consumer prices have risen this year more than many Fed officials expected, they may issue a statement after their meeting today that emphasizes that the pace of future interest rate increases will depend on consumer price trends. If inflation remains restrained, they will proceed at a gradual pace; if prices keep rising, the policymakers will raise rates more aggressively, in bigger or more frequent steps.

Some analysts, for example, predict that tame inflation will allow the Fed to follow today's action by raising their target in two additional quarter-point steps, to 1.75 percent by year-end. After adjusting for inflation, that would still leave the target at an extremely stimulative level. Other analysts predict that higher inflation will force the Fed to raise the target to around 2.25 percent by the end of the year, which also would be extremely stimulative on an inflation-adjusted basis.