The Federal Reserve, as widely expected, raised short-term interest rates by a quarter of a percentage point yesterday but startled financial markets with an announcement indicating that further rate increases aren't necessarily on the way.
The Fed's statement sparked strong rallies in both the stock and bond markets, where many investors had worried that the central bank might be planning a series of rate increases in coming months to cool off hot U.S. economic growth and keep inflation low.
The Standard & Poor's 500-stock index and Nasdaq composite index both closed at record highs. The Dow Jones industrial average did almost as well, rising 155.45 points to close at 10,970.80, slightly below its record high of 11,107.19.
Meanwhile, the price of a 30-year U.S. Treasury bond rose as its yield, which goes down when the price goes up, fell to 5.96 percent, from 6.06 percent on Tuesday. Yields on some shorter-term Treasury securities, such as two-year notes, fell even more.
The Fed's action helped push borrowing costs higher for millions of U.S. consumers and businesses. After the Fed's announcement, major banks such as Bank of America raised their 7.75 percent prime lending rates to 8 percent, effective today. Rates on many small-business and personal loans, including credit card and home equity loans, are tied to the prime. But rates on 30-year fixed-rate home mortgages have gone up in recent weeks along with other long-term rates and could now fall if yesterday's drop in note and bond yields continues.
Higher rates typically slow economic growth by restraining business investment and consumer purchases. But a rising stock market could well fuel continued robust spending.
Bill Dudley, chief economist at Goldman Sachs Group Inc. in New York, was among the analysts puzzled by the tone of the Fed announcement.
"It was definitely a market-friendly statement," Dudley said. "Why would the Fed want to sound so friendly when they want to temper economic growth?"
On the other hand, Dudley cautioned, "the market may be making too much out of the statement, because if the economy stays firm we are going to be in exactly the same situation at the next policymaking meeting and they could make the same decision" to raise rates.
The Fed increased its target for overnight interest rates to 5 percent from 4.75 percent, its first increase in more than two years. The Fed cut rates last fall by 0.75 percentage points in three steps to counter the crisis then buffeting U.S. financial markets.
"Since then much of the financial strain has eased, foreign economies have firmed and economic activity in the United States has moved forward at a brisk pace. Accordingly, the full degree of adjustment is judged no longer necessary," the Fed's top policymaking group, the Federal Open Market Committee, said in a statement.
Many analysts had expected the Fed to also warn that brisk growth must slow if inflation is to remain tame. But instead, the FOMC announcement noted that "strengthening productivity growth has contained inflationary pressures."
And instead of an announcement that the committee was still leaning in the direction of raising rates in coming months, the FOMC said it had adopted a neutral direction, indicating that its next move on rates is as likely to be a decrease as an increase.
The FOMC "recognizes that in the current environment it must be especially alert to the emergence, or potential emergence, of inflationary forces that could undermine economic growth," the statement concluded. The panel will next meet on Aug. 24.
Fed Chairman Alan Greenspan telegraphed yesterday's action in a series of speeches and congressional testimonies beginning in early May. But almost all Fed watchers expected much more hawkish language on inflation to accompany the rate increase.
The FOMC "basically moved to a clean slate," said Mickey Levy, chief economist for Bank of America in New York. "They told us that if economic conditions merit it, we will tighten again. If they don't, we won't."
Levy speculated that a factor behind the Fed's neutral language may have been market expectations of a series of rate increases. He pointed out that rates on longer-term securities had gone up sharply in recent weeks and that some private corporate borrowers were having trouble selling new issues of notes and bonds.
"I think they were very sensitive to a potential adverse impact on financial markets" if the FOMC statement sounded too hawkish, he said. That concern may have been heightened by the committee's new effort to disclose to the public information about whether it is leaning one way or the other in terms of future action on rates, he added.
"The neutral stance does not preclude further tightening, should economic and financial conditions warrant, but it does reduce the probability of an increase at the August meeting," Levy said.
Sen. Tom Harkin (D-Iowa) was one of a number of Fed critics who complained that yesterday's rate increase was unnecessary.
"Unfortunately, the Federal Reserve has allowed their inordinate fear of inflation to put America's strong economy in jeopardy," Harkin said in a statement. The fallout of an interest rate hike is an unnecessary tax on every business and on every family with an adjustable mortgage or purchasing a car."
How a Fed Rate Increase May Affect Consumers, Business and the Markets
The Fed raises its target for short-term rates by making less reserves available to banks, effectively sucking money out of the system.
Banks' cost of funds is raised. Banks normally follow by raising rates charged to borrowers, for example by increasing their prime rate, the reference rate for many loans to businesses and consumers.
Businesses may pay higher interest rates on all types of loans, including those tied to the prime.
Consumers may see the effects in higher rates for credit cards, home-equity lines of credit, some personal loans and others that often are tied to the prime rate. New loans not tied to the prime rate also may cost more. Banks also may or may not pay higher rates to depositors on their holdings in certificates of deposit, money-market accounts and interest-bearing checking accounts.
The stock market could weaken as higher borrowing costs squeeze companies' profits. The bond market also might weaken further if investors expect more rate increases. But many analysts believe prices in both markets had fully adjusted in anticipation of yesterday's Fed rate increase.
The economy: Higher borrowing costs may slow economic growth by making it harder for firms to expand and invest and for consumers to keep spending. Higher rates could trigger layoffs, which also would depress spending.
Internationally, higher U.S. rates will help keep the dollar's value up, which will hold down U.S. inflation while increasing the cost of U.S. exports to foreign buyers. The latter will also tend to hold down economic growth somewhat.
CAPTION: THE DOW'S DAY (This chart was not available)