The Federal Reserve, noting recent signs of economic strengthening, yesterday raised a key short-term interest rate for the fourth time this year to prevent inflationary pressures from building.
Fed policymakers, in a statement issued after their rate-setting meeting, sounded slightly more upbeat about the economy's performance than after their previous meeting in September, leading many financial analysts to conclude that the central bank will nudge up its benchmark rate again in December.
But some observers cautioned that the Fed officials' statement left open the option of leaving rates unchanged at the central bank's meeting next month if the economy falters. Economic output "appears to be growing at a moderate pace despite the rise in energy prices, and labor market conditions have improved," Fed officials said in their statement.
The policymakers decided unanimously to raise the federal funds rate -- the rate charged on overnight loans between banks -- to 2 percent from 1.75 percent. The rate influences many other business and consumer borrowing costs, which are determined by financial markets.
Banks responded by raising their prime lending rate for business loans to 5 percent from 4.75 percent. Consumer rates that are linked to the prime rate, such as those on many home equity loans and credit cards, may rise by as much.
Stocks were little changed by the close of trading yesterday, in part because the Fed action had been widely anticipated in financial markets. Stocks rallied initially, as investors interpreted the Fed's economic assessment yesterday as sunnier than before. The Fed's action marked its fourth consecutive rate increase since late June, when the funds rate was at 1 percent -- the lowest level since 1958. Fed officials started raising the rate at their June meeting after leaving it at 1 percent for the previous year, providing an "emergency" level of economic stimulus to support a wobbly economic expansion and prevent deflation -- a damaging drop in the overall price level.
At 2 percent, the rate is still very low and should continue to stimulate economic growth by encouraging borrowers to keep spending.
The Fed's rate increases so far have had no noticeable slowing effect on the economy. Longer-term interest rates, while influenced by the Fed, are determined by financial markets in response to a variety of factors and have remained relatively low in recent months.
For example, the national average rate on a 30-year mortgage reached its highest point this year in May, at 6.34 percent, and has drifted generally lower since. The average rate was 5.7 percent last week, compared with 5.94 percent in the same week a year ago. Low mortgage rates, in turn, have continued to stoke the booming housing market, providing a significant source of economic growth.
Low long-term rates generally reflect the financial markets' expectations of tame inflation and modest economic growth in the months ahead, which implies continued mild demand for business loans.
Changes in the Fed's benchmark rate also affect the economy with a time lag of many months. That means that an increase now may not be felt in the economy until spring.
Therefore, Fed officials set the rate with an eye on how the economy is likely to be doing next year, rather than next month. They are considering not just what to do at the December meeting, but also how briskly or gingerly to raise rates in the coming year. The answer will depend on how vigorously the economy grows and how restrained inflation and inflation expectations appear to be.
The Fed started raising the rate in June because the economy had grown at a quick clip early this year, making very low rates unnecessary and raising the risk that they would fuel inflationary pressures in the future.
Fed officials kept raising the funds rate through the summer and fall even after the economy cooled markedly in the early summer. The economy grew at a 3.3 percent annual rate in the April-through-June quarter, well below the 4.5 percent rate of the first three months of the year. Many analysts blamed the slowdown in large part on oil prices, which rose above $40 a barrel for the first time in May.
The economy picked up some steam in subsequent months, expanding at a 3.7 percent rate in the July-through-September quarter.
But many forecasters now expect the economy to grow at an annualized pace below 4 percent in the quarters ahead, in part because of the most recent run-up in energy prices, including those for gasoline, diesel fuel, heating oil and natural gas. Oil prices exceeded $55 a barrel for the first time in October, though they have receded since then to around $49 in recent days.
Rising energy costs were "constraining consumer and business spending" across the country in September and early October, according to the Fed's most recent survey of regional economic conditions, called the Beige Book.
Several Fed officials have indicated that they think the economy is likely to keep growing at a solid rate, but some are more worried than others about a variety of risks to growth.
Fed Vice Chairman Roger W. Ferguson Jr., in a recent speech, laid out the case for slowing the pace of increases by citing concerns about high energy costs, the country's large trade deficit and signs of continued business reluctance to hire and expand production. He also indicated the Fed wants to keep the funds rate low enough to continue stimulating the economy so it will grow fast enough to absorb "underused resources," a reference to the nation's ample supply of unemployed workers and unused production capacity.
When the Fed started raising rates in June, policymakers expected the economy to be growing at a faster pace by now. They spoke then about moving the rate toward a so-called neutral level, which would neither stimulate or slow growth.
But Ferguson said less than two weeks ago, "It is very important that the FOMC not go on a forced march" to lift the funds rate to a neutral level. Ferguson's comments, which echoed those of some Fed colleagues, caused many analysts to expect the Fed to pause in December. But since his speech, delivered Oct. 29, signs of economic improvement have appeared in reports of stronger job creation, rising exports and continued healthy increases in consumer spending.
Another issue for the Fed is the recent fall in the dollar, which should help the economy by making U.S. products cheaper relative to those made elsewhere, and thus more competitive at home and abroad.
If the dollar continues to decline, that should help boost economic growth, but also might fuel inflation by causing import prices to rise -- as they did last month. That might justify raising interest rates more than otherwise.
For now, "inflation and longer-term inflation expectations remain well contained," the Fed statement said.
But shorter-term inflation expectations have risen recently, said James O'Sullivan, U.S. economist at UBS Investment Bank. "There is no effort here to dissuade people from expecting another move in December," he said of the Fed statement.
But that, said Robert DiClemente, chief U.S. economist for Citigroup, could make a decision to pause in December "a pleasant surprise. . . . They have every option to pause."