Optimistic Fed Raises Key Rate

The Federal Reserve on Tuesday raised interest rates again despite recent signs of economic weakness, and declared that more tightening was needed to keep inflationary pressure contained.

The central bank’s policymaking committee increased its benchmark federal funds rate on overnight loans between banks to 1.5% from 1.25%.

Fed officials acknowledged that economic growth and job creation had slowed in recent months. But they blamed the softness largely on spiking oil prices, and said the economy “appears poised to resume a stronger pace of expansion going forward.”

Noting that inflation had been “somewhat elevated,” they said they intended to continue on a path of “measured” interest rate increases to prevent prices from spiraling upward.

That statement damped recent speculation that economic sluggishness might prompt the Fed to refrain from hiking rates at its next meeting Sept. 21 or even for the rest of this year. The Fed now is likely to raise rates in quarter-point increments at each of its three remaining meetings in 2004, analysts said.

“The Fed appears to be confident that this pause” in economic growth “has been temporary,” said Lynn Reaser, chief economist at Banc of America Capital Management in St. Louis. “At this point, I think they have it right.”

For weeks, Fed Chairman Alan Greenspan and other central bank officials had been telegraphing their intent to keep raising rates. Analysts said they would have appeared inconsistent -- and perhaps politically motivated -- if they had changed course in response to one or two bad economic reports such as last week’s disappointing news on job creation.

“They did not want to send a message that the economy is so bad they had to change course,” said Sung Won Sohn, chief economist at Wells Fargo & Co. in Minneapolis. “That would be exactly the wrong message.”

Encouraged by the Fed’s assessment that the slowdown was temporary, investors drove up stock prices Tuesday.

Even with the latest boost, short-term interest rates remain near their lowest level since the early 1960s. Tuesday’s rate increase was the second hike in four years, after an initial increase on June 30.

The political repercussions of the rate hike may turn out to be more significant than its immediate economic effect, some analysts said.

The direct effect of the Fed’s action will be limited mainly to some credit card accounts and business, auto and home-equity loans. Those rates will rise because banks across the country Tuesday raised their so-called prime lending rate -- to which many loans are pegged -- to 4.5% from 4.25% in response to the Fed’s action.

The quarter-point increase was widely expected. Most long-term interest rates, including those on home mortgages, had risen this year in anticipation of several Fed rate increases. However, long-term rates, which are determined by the markets, have fallen in recent weeks amid signs of slowing economic growth.

The latest rate hike could add fuel to the political debate over the course of the recovery and the Bush administration’s economic policies, analysts said.

Although the Fed acts independently of the White House, many Americans perceive it to be part of the same Washington policymaking establishment.

President Bush’s handling of the economy has become a central issue in this year’s election debate. Democratic nominee Sen. John F. Kerry of Massachusetts has accused him of not doing enough to stimulate the recovery and promote job formation.

Bush, in turn, has said his tax cuts and other initiatives were the right medicine for an ailing economy. Citing nearly a year’s worth of employment growth, he insisted as recently as last week that the economy had “turned the corner” on jobs.

Those claims were called into question Friday by a surprisingly weak employment report showing that the U.S. economy added only 32,000 net jobs in July, far less than in previous months.

Although other data in the July report signaled continued improvement, the anemic job creation figure fueled fears that the recovery could be stalling in response to high oil prices, fading fiscal stimulus and rising interest rates.

Kerry and his economic advisors had no immediate comment Tuesday on the Fed rate hike.

Before Tuesday’s announcement, some political analysts said a rate hike would seem out of sync with the latest economic signals, and risked a potential political backlash. But several economists said the Fed faced even bigger risks if it changed course abruptly.

“In some respects, they backed themselves into a corner with the ‘measured’ interest rate hike hints they’ve been dropping for the last three months,” said Greg McBride, senior analyst with Bankrate.com.

McBride said the wisdom of Tuesday’s rate hike would depend on whether Greenspan was correct in predicting that the recent economic “soft patch” would be short-lived. “If it proves to be, then today’s rate hike is a good move,” McBride said.

Even with the latest increase, short-term interest rates remain well below the supposed “neutral” point at which they are believed to neither stimulate nor discourage economic growth. Estimates vary, but many analysts believe that point to be about 3.5% to 4.5%.

Although inflation remains quite low by historical standards, Fed officials have expressed concern about recent signs of rising prices. Fueled in part by high oil prices, the consumer price index is up more than 3% over the last 12 months.

Recent signals about the economy’s health have been mixed. Growth in the nation’s gross domestic product slowed to 3% in the second quarter from 4.5% in the first quarter. But consumer confidence remains high, and some indicators suggest the job market is strengthening.