Federal Reserve officials yesterday expressed confidence that the economy will regain momentum in the months ahead and raised a key short-term interest rate to ensure inflation remains under control.
Fed policymakers, in a statement issued after their meeting, blamed high energy prices for the recent sharp slowdown in economic growth and job gains. They made clear they still view that "softness" as temporary and believe they can likely stick to their plan of lifting rates gradually as the expansion continues.
The Fed's action appeared to dismiss concerns that the economic recovery is faltering again, just months before a presidential election that could hinge on perceptions of the economy's health. While presidents in the past have urged the Fed to keep rates as low as possible, President Bush characterized the Fed's last rate increase, in June, as a sign the economy is getting stronger.
But critics said that by blaming oil prices for the recent dip in economic growth, the Fed was playing down the role of weak job and income growth in cooling the economy.
Stock prices scored their biggest gains in two months following the Fed's action, as many investors were more heartened by the Fed's optimistic outlook than they were worried that higher interest rates will slow growth. The Dow Jones industrial average gained 130 points, or 1.3 percent.
The economy "appears poised to resume a stronger pace of expansion going forward," the Federal Open Market Committee, the central bank's top policymaking group, declared in its statement.
The committee's emphatic language indicated the Fed would maintain its plan for a series of gradual rate increases in the face of growing uncertainty about the economy's underlying strength. Some analysts argue that the recent economic slowdown simply reveals weaknesses masked in recent years by tax cuts and the Fed's own interest rate policies. Continuing to raise rates in such an environment, they contend, risks undermining the recovery.
Fed officials agreed unanimously to nudge their federal funds rate -- the interest rate charged between banks on overnight loans -- to 1.50 percent from 1.25 percent. The rate influences many other business and household borrowing costs throughout the economy.
Banks responded to the Fed announcement by raising their prime lending rate for business loans to 4.50 percent from 4.25 percent. That means consumer rates that are tied to the prime rate, such as many home-equity loans and credit cards, will likely rise by as much.
But rates are still so low by historical standards that they should continue to stimulate economic growth by encouraging borrowers to take on more debt. The central bank did not raise rates to slow the economy, but rather to ensure that inflationary pressures do not build. Lifting them by a small amount at this point is more like easing up on the economy's accelerator than like tapping the brake.
The Fed's message "is they still view the pause we've seen recently as temporary," said Lynn Reaser, chief economist for Banc of America Capital Management. "The inference is that oil prices are unlikely to continue to rise at the pace we've seen."
Reaser said she agrees with the Fed's analysis, but added that oil "remains a risk" to the forecast.
The Fed committee said yesterday that the recent "softness likely owes importantly to the substantial rise in energy prices."
The economy grew at a 3 percent annual rate in the April-through-June quarter, the slowest pace in more than a year and well below the 4.5 percent of the first three months of the year.
Meanwhile, job growth slowed dramatically in the second quarter, with employers adding just 78,000 jobs in June and 32,000 in July -- such small gains that statisticians view the totals as essentially unchanged.
Although oil prices had receded somewhat from their highs in May, they climbed to new records in the last week on fears of global supply disruptions. Light crude scheduled for September delivery rose above $45 a barrel during trading yesterday, before closing at $44.52 on the New York Mercantile Exchange.
The recent surge has renewed concerns that energy costs may continue to sap consumer spending and the economy's overall strength. But if oil prices stabilize, those effects should dissipate, said Mickey D. Levy, chief economist for Bank of America.
The Fed's action "wisely" shows it "is distinguishing between transitory factors and the underlying trends," Levy said.
Critics challenged the Fed action from both sides, with some saying it should not have raised rates, and others saying it is lifting them too slowly.
"The softness in the economy isn't mostly about oil," said Jared Bernstein, senior economist at the Economic Policy Institute, a think tank that focuses on labor issues. "It's as much about the weakening labor market, and raising rates is precisely the wrong medicine for that problem."
Peter Schiff, president of Euro Pacific Capital Inc., wrote in an analysis that the Fed statement paints "an unwarranted rosy picture of the prospects for the U.S. economy." He argues that the Fed has already held rates too low for too long, allowing inflationary pressures to build while encouraging too much borrowing.
"The 'oil card' allows the Fed to deflect attention from the real culprits, which are excessive debt and insufficient income growth," he said. "These problems, far from being transitory, are systemic, and will only worsen, especially as interest rates rise."
At their previous meeting in late June, Fed officials raised their benchmark rate to 1.25 percent after leaving it at 1 percent for a year, the lowest level since 1958. They had dropped it so low to help the economy recover from the 2001 recession, and to prevent deflation, a dangerous drop in overall prices.
By the June meeting, Fed officials indicated that they believed the economy had strengthened to the point where they should raise rates to more normal levels before inflation became a problem.
In their statement yesterday, they repeated that they would likely raise rates at a "measured" pace, meaning small increases over many months, depending on how the economic recovery proceeds.
Among the factors the Fed will watch closely are businesses' labor costs, which are a key to inflation trends.
Businesses' costs of labor per unit of output rose at a 1.9 percent annual rate in the second quarter, the biggest jump in two years, following a 0.3 percent increase in the first quarter, the Labor Department reported yesterday.
That's in sharp contrast to the decline in unit labor costs that had prevailed through much of the recovery, causing inflation to fall to very low levels.
Hourly compensation, which includes wages, salaries, bonuses and benefits, rose at a 4.9 percent annual rate in the second quarter. But the increase was a much more meager 0.1 percent after adjusting for inflation, the report said.
The ability of businesses to produce more goods and services without adding to their payrolls reflects strong growth in productivity, or output per hour worked.
Productivity at non-farm businesses rose at a seasonally adjusted 2.9 percent annual rate in the second quarter. That is a healthy number in historical terms, but it marks the slowest increase since late 2002, and a drop from 3.7 percent in the first quarter, the Labor Department reported yesterday.
Greenspan has said that eventually productivity growth will slow, and employers will have to hire more workers to keep up with rising demand for goods and services. But he also said it is difficult to predict when that would happen.