Fed Raises Key Interest Rate by Quarter-Point

Mortgage rates, for example, have been rising for months. The average 30-year fixed-rate reached 6.25 percent last week, up from its low this year at 5.38 percent in March, according to mortgage financier Freddie Mac. Wall Street economists generally forecast the rate to reach 6.6 percent by the end of the year, and 6.7 percent by June of next year, according to a survey released Tuesday by The Bond Market Association.

Banks, on the other hand, are likely to respond to the Fed action today by raising their prime lending rate for business loans to 4.25 percent from 4 percent, and by continuing to move it up in coming months with each increase in the Fed funds rate.

Many economists forecast the Fed's rate target to rise slowly to around 2 percent by the end of this year, and to somewhere between 3.5 percent to 4.5 percent by the end of 2005.

The Fed is raising rates not to slow the economy, but rather to ensure that it does not grow so rapidly that inflation takes off.

At 1.25 percent, the target remains extremely low and should continue to stimulate economic growth, but just a little more lightly than it did at 1 percent, economists said. Thus the Fed's action is more like lifting a little pressure off the economy's accelerator than like touching the brakes.

Higher borrowing costs tend to restrain household and business spending, which helps keep the lid on inflation in a rapidly growing economy. Lower rates tend to encourage spending, which helps spur economic growth. The Fed last raised the target to 6.5 percent in May 2000, at the height of the recent boom.

The Fed started lowering its benchmark rate in early 2001 as the slowing economy headed into recession, and kept cutting it through the downturn and sluggish recovery that followed.

Until last summer, businesses had been reluctant to invest or hire, in part because they had ample unused production capacity left over from the boom. But low interest rates, combined with federal tax cuts, persuaded consumers to keep spending through the recession and recovery, even as the economy was shaken by the Sept. 11, 2001, terrorist attacks, a wave of corporate scandals and the war in Iraq.

Then last June, Fed officials lowered their rate target to 1 percent, the lowest level since 1958, both to keep supporting the economic recovery and to prevent deflation, a destabilizing drop in the overall price level.

Interest rates fell throughout the economy -- the average 30-year-fixed rate mortgage tumbled to 5.24 percent last June -- and consumers and businesses went on a borrowing and spending binge. With another tax cut adding more fuel to the fire, the economy grew at a sizzling 8.2 percent annual rate last summer.

But as the stimulus from the tax cuts and home-loan refinancing waned, the economic growth slowed to a milder, but still healthy, annual rate around 4 percent during the months since.

Fed officials left their target so low for so long in part because the economic recovery failed to produce robust job creation until recently.

Now, with the economy expanding steadily, businesses hiring with renewed vigor and inflation remaining relatively low, Fed officials believe they should move rates up from the abnormally low levels of the last year.