Federal Reserve officials yesterday raised a key short-term interest rate for the first time in four years and signaled that they would probably nudge rates higher as the economy grows stronger.
Rate increases could become more aggressive if inflation pressures continue to build, officials indicated. But in a statement issued at the conclusion of their two-day meeting in Washington, the policymakers said they can raise rates "at a pace that is likely to be measured," because they expect inflation to remain "relatively low."
The 12 members of the Federal Open Market Committee voted unanimously to lift their target for the federal funds rate -- which influences borrowing costs throughout the economy -- to 1.25 percent from 1 percent, where it had been for the past year. Financial markets had little reaction to the afternoon announcement of the rate increase, which had been widely expected. Stock and bond prices rose slightly.
The Fed is raising the rate not to slow the economy, but rather to ensure that it does not grow so rapidly that inflation takes off.
The action "should not be interpreted as an attempt to brake an out-of-control economy," said Richard A. Yamarone, director of economic research at Argus Research Corp. He said the rate increase is "more appropriately analogous to taking the foot off the accelerator."
The Fed committee emphasized that it is prepared to abandon its plan for small rate increases, of a quarter-percentage point at a time, if its tame forecasts of "underlying inflation" -- which excludes volatile energy and food prices -- prove to be wrong. In the statement, the officials said the Fed "will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability."
The statement effectively warned financial markets that the Fed must have flexibility to respond to changing conditions in an economy still in transition from a wobbly recovery to a sustained expansion.
If inflation pressures pick up, the committee could raise rates more frequently, or in larger increments than implied by a "measured pace." If economic growth falters and inflation falls to dangerously low levels, the committee could stop raising its target for a while, or even lower it again in response to an economic shock, such as a stock market crash or terrorist attack.
Because Fed officials have signaled for a while that they would start raising their rate target gradually, many borrowers are already paying higher rates and are likely to see rates continue to climb for a while.
The Fed funds rate, charged on overnight loans between banks, influences other interest rates determined by banks and financial markets, such as those on mortgages, credit cards, home-equity loans and other forms of household and business borrowing.
Mortgage rates, for example, have been inching up 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 2005, according to a survey released Tuesday by the Bond Market Association.
Several banks responded to the Fed action yesterday by raising their prime lending rates for business loans to 4.25 percent from 4 percent. They are likely to continue raising it 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. That means that relatively low rates will continue to stimulate economic growth for many months.
Higher borrowing costs restrain household and business spending, which helps keep a lid on inflation in a rapidly growing economy. Lower rates encourage spending, which helps spur economic growth. The Fed last raised the target in May 2000, to 6.5 percent, at the height of the recent boom.
The Fed started lowering its benchmark rate in early 2001 as the economy slowed and headed into recession. It kept cutting its target 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, corporate scandals and the war in Iraq.
Then last June, the federal funds rate was lowered to 1 percent -- the lowest since 1958 -- to keep spurring an economic recovery and to prevent deflation, a destabilizing drop in overall prices.
Interest rates fell throughout the economy -- the average 30-year-fixed rate mortgage was 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 an 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.
Fed officials left their target so low for so long in part because businesses remained reluctant to hire at a robust pace until very recently. Even after adding nearly 1 million jobs in the past three months, the nation still had 1.3 million fewer jobs in May than it had in March 2001 when the recession began.
With the economy now expanding steadily, businesses hiring with renewed vigor and inflation remaining low, Fed officials believe they should move rates up from the abnormally low levels of the past year.
However, the policymakers also remain cautious about the economic outlook because of several sources of uncertainty.
Inflation, for example, surprised them this year by rising more than they had forecast. They believe much of that surge -- particularly in prices for oil, steel and many other raw materials -- reflects passing factors, such as the Middle East tensions. Many of those prices have fallen recently, but they cannot know whether they will rise again. Fed officials also have noted that businesses have not borrowed as much money through bond issues as might be expected during a vigorous recovery, suggesting that some remain cautious about whether to invest in new plants and equipment in anticipation of rising demand.
If so, then it's hard for the Fed to know whether the recent burst of hiring will persist or ebb.
Some analysts agreed with the Fed's gradual approach to raising rates. "There are good reasons" for it, said Sung Won Sohn, chief economist at Wells Fargo Economics. "Inflation, though rising, is under control . . . . The high price of oil associated with geopolitics and terrorism argues against taking too much economic risk at this time."
But others worried that the Fed is moving too cautiously.
"The Fed is seemingly too sanguine about the recent rise in inflation, which is due to fundamentals rather than transitory factors," said Mickey D. Levy, chief economist at Bank of America. "The Fed is taking a risk in its current risk assessment."