Fed Raises Key Interest Rate to 2.25%

The Federal Reserve made it five-for-five Tuesday, raising its benchmark short-term interest rate to 2.25% from 2%, the fifth quarter-point increase in as many meetings since June.

Expect more of the same in 2005: Policymakers’ post-meeting statement indicated that they are likely to continue tightening credit at this year’s pace.

Wall Street had been all but certain of another rate hike, after data in recent weeks that have mostly pointed to a growing U.S. economy. Stocks rallied modestly Tuesday and long-term bond yields eased.

In September and October, some Fed watchers predicted that the central bank would keep its key rate steady at this month’s meeting to get a better sense of the economy’s trend.

But “there’s nothing really out there suggesting that the Fed should pause,” said Peter Hooper, economist at Deutsche Bank Securities in New York.

The nation added a net 112,000 jobs in November, the Labor Department said Dec. 3. That was below what many analysts expected, but it wasn’t weak enough to cause the Fed concern about the economy, Hooper said.

Although job growth was disappointing last month, analysts have been impressed by gains in retail sales, industrial activity and business confidence. Also, the steep drop in oil prices since late October has bolstered optimism about consumer spending in 2005.

Using language almost identical to what was in its Nov. 10 meeting statement, the central bank Tuesday said the economy’s “output appears to be growing at a moderate pace despite the earlier rise in energy prices,” and declared that “labor market conditions continue to improve gradually.”

As in its previous four statements, the Fed signaled that it expected to continue to raise short-term rates as the economy expands, and “at a pace that is likely to be measured” -- which most analysts say will mean a succession of quarter-point increases in the benchmark federal funds rate, the overnight loan rate among banks.

The immediate effect of Tuesday’s rate hike will be to raise other short-term borrowing and savings rates. Many major banks quickly raised their prime lending rates by a quarter point, to 5.25%. Rates on money market funds and bank certificates of deposit also will continue to rise, analysts say.

But long-term interest rates, such as on Treasury bonds and mortgages, are set by the marketplace rather than the Fed. Those rates have declined since the Fed’s Nov. 10 meeting, in part reflecting that investors believe inflation won’t rise significantly, said Steven Wieting, economist at Citigroup Global Markets in New York.

The yield on the 10-year Treasury note dipped to 4.12% on Tuesday from 4.15% on Monday. It is down from 4.24% on Nov. 10.

“Long-term inflation expectations have stayed low,” Wieting said. Inflation is considered the biggest threat to bond investors because it erodes the securities’ fixed-rate returns, he noted.

In its statement Tuesday, the Fed repeated wording it used in November, saying that “inflation and longer-term inflation expectations remain well contained.”

That language was aimed at further reinforcing the idea that policymakers don’t feel any urgency to raise interest rates at a faster pace that could quickly cool the economy and damp inflation pressures, analysts said.

At 2.25% the Fed’s key rate is the highest since November 2001, and is more than double the 46-year low of 1% the central bank maintained from mid-2003 until June in an effort to keep the economy advancing.

Most analysts believe that, barring a sudden hiccup in U.S. growth, the Fed will continue gradually raising its rate until it reaches a “neutral” level -- meaning a point at which short-term interest rates are neither stimulative nor depressive to the economy.

But there is no consensus on what would constitute a neutral rate. Some analysts say it could be a federal funds rate between 3.5% and 4%; others say the Fed might not stop until it reaches 5% or so.

The dollar’s value relative to other currencies could be a wild card in the Fed’s future deliberations. The dollar has tumbled in recent months, stoking concerns that foreign investors might bail out of U.S. bonds and other assets rather than risk further devaluation of their holdings.

By raising interest rates the Fed helps to make returns on short-term bonds more appealing, which could attract more foreign money into those securities and boost the dollar.

For now, even the Fed may not know how high it will push interest rates, experts say. “Their best judgment is that rates ought to be higher,” Wieting said, but where the top might be isn’t clear, he said.

In a technical move Tuesday, the Fed said it would begin releasing the minutes of its meetings three weeks after the fact, instead of six weeks later. The decision is part of the Fed’s efforts to be more open about its operations, analysts said.

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Outlook for key rates

Item: Prime lending rate

Current rate: 5.25%

Outlook: Major banks raised the prime a quarter-point Tuesday, matching the Fed’s increase. Most banks are expected to follow. The prime, a benchmark for many consumer loans, usually changes in tandem with Fed shifts. The next Fed meeting: Feb. 2.

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Item: Money market mutual fund average yield (seven-day)

Current rate: 1.43%

Outlook: Money fund yields usually track Fed rate changes, with a lag time of six to eight weeks. The average money fund yield has risen 0.19 point since the Fed’s last quarter-point rate hike Nov. 10.

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Item: Six-month CD yield (U.S. average)

Current rate: 1.57%

Outlook: Certificate of deposit yields rose slowly when the Fed first began lifting short-term rates in June, but banks have picked up the pace in recent weeks. The average six-month CD yield has risen 0.14 point since Nov. 10. Yields are expected to continue moving up.

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Item: 10-year Treasury note yield

Current rate: 4.12%

Outlook: Long-term bond yields have declined modestly since the Fed’s last meeting. Bond rates are set by the marketplace, not by the Fed. Investors’ willingness to accept lower yields in part reflects faith that inflation won’t surge, analysts say.

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Item: 30-year mortgage rate (Freddie Mac average)

Current rate: 5.71%

Outlook: Mortgage rates generally follow long-term bond yields. The 30-year mortgage rate was 5.76% when the Fed met in November.