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Key Fed Rate Raised to 5.25%, A 5-Year High

By Nell Henderson
Washington Post Staff Writer
Friday, June 30, 2006

Federal Reserve policymakers raised a key interest rate yesterday to the highest level in more than five years and signaled that they may lift it further to combat rising inflation.

Consumer price inflation "has been elevated in recent months," the Federal Open Market Committee, the central bank's top policymaking group, said in a statement after announcing its decision to raise its benchmark interest rate to 5.25 percent from 5 percent, the 17th consecutive quarter-percentage-point increase since June 2004.

The Fed has been tightening credit to cool the economy and keep inflation under control. The rate increases have succeeded in slowing economic growth from its rapid pace of earlier this year, primarily by letting some air out of the housing market, the committee noted in its statement.

But the economy did not slow enough to prevent inflation from edging up in the spring, in part because energy costs soared and more businesses were able to pass them on to consumers by raising retail prices. Fed policymakers said the slowdown "should help to limit inflation pressures over time" but suggested that may not be enough by itself to force inflation back down.

"Some inflation risks remain," the committee said, indicating that it might raise the benchmark rate again in coming months if inflation proves stubborn. But it also left open the possibility of keeping the rate stable at its next policymaking meeting in August if price pressures ebb. Stock markets rallied on that news.

The committee's "objective here is to tell the markets the Fed will keep its eye on inflation, but it's going to be flexible," said Ethan S. Harris, chief U.S. economist at Lehman Brothers Inc. The Fed "is not oblivious to the risks to growth," he said. "We expect them to hike in August, but it's not a done deal by any stretch."

The benchmark federal funds rate, which is charged on overnight loans between banks, influences many other borrowing costs. Major banks followed the Fed's action by raising their prime rate on business loans to 8.25 percent from 8 percent. Interest rates charged on credit cards, home equity loans and mortgages are likely to rise as well, but savers should benefit as financial institutions pay out higher rates on money-market funds and certificates of deposit.

Interest rates on long-term loans have been rising in recent months, although more slowly than short-term rates. The average rate on a 30-year fixed-rate mortgage, for example, was 6.71 percent last week, not much higher than its 6.29 percent level in June 2004, just before the Fed started raising the federal funds rate.

The Fed uses its influence over interest rates to promote economic growth while keeping inflation contained. Higher interest rates cause consumers and businesses to spend less, slowing economic growth and dampening inflation pressures. Lower rates do the opposite.

Fed policymakers raised their benchmark rate to 6.5 percent in 2000 at the peak of the stock-market boom. By early 2001, with stock prices falling and the economy losing momentum, the Fed started lowering the rate. The central bank continued cutting the rate through the recession, terrorist attacks that year and through the initially sluggish expansion that followed, to a four-decade low of 1 percent in June 2003.

Other borrowing costs plunged, spurring consumers to buy cars with interest-free loans and real estate with cheap mortgages. The housing market boomed, allowing consumers to spend more by borrowing against the rising equity in their homes. Economic growth picked up and unemployment started to fall.

Central bankers held their benchmark the rate at 1 percent for a year, until June 2004, when they thought the economy had strengthened enough to no longer need the extra support. In January this year, at Alan Greenspan's last open-market committee meeting as Fed chairman, the committee raised the rate to 4.5 percent, a level many members believed was about "neutral" -- that is, no longer providing the stimulus of low rates but not high enough to restrict growth.

Some Fed policymakers had hoped to be able to stop raising the rate at that point. But inflation pressures were building. The economy grew at a 5.6 percent annual rate in the first three months of this year, the fastest pace in more than two years, the Commerce Department reported yesterday, revising its earlier, slightly lower estimates. Energy prices rose through the winter and spring. Businesses also paid more for copper, lumber, pulp and many other raw materials, and started passing more of their costs to consumers through higher prices.

The Labor Department's consumer price index, a widely followed inflation gauge, rose 4.2 percent in the 12 months that ended in May. That compares with a 3.4 percent inflation rate in 2005, which was a five-year high.

The core CPI, which excludes food and energy prices, has also gone up in recent months.

The Fed committee raised the rate again in March, at Ben S. Bernanke's first meeting as chairman, and at its meetings in May and yesterday.

Economic growth has slowed sharply in the second quarter, according to many analysts' estimates. Fed policymakers have said they expect the economy to grow at an annual rate of about 3 percent in the months ahead, which should help reduce inflation.

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