Fed Raises Key Interest Rate to Avert Inflation
The Federal Reserve began lowering the curtain on the cheapest money in nearly a half-century Wednesday by raising its key short-term interest rate a quarter-point, to 1.25%, and promising further rate hikes at a “measured” pace.
Policymakers had so successfully telegraphed their plan to raise rates that long-term interest rates, which are determined by the marketplace, actually dipped after the news of the first Fed increase since May 2000.
As a result, many consumers won’t feel too much of an immediate additional pinch, analysts said.
“Mortgage rates have already gone up in anticipation of this. Life has gotten a little more expensive,” said Goldman Sachs economist Edward F. McKelvey. But “it’s not going to be a deal breaker for most people,” he added, at least not right away.
However, the decision to raise the federal funds rate -- what banks charge one another for overnight loans -- will result in noticeably higher borrowing burdens for consumers with enormous debts on credit cards, home equity loans or other variable-rate loans. Banks and other lenders followed the Fed hike by raising their so-called prime lending rates to 4.25% from 4% on Wednesday. Home equity loans, variable-rate credit cards and some other personal loans are usually tied to the prime rate.
Wednesday’s rate increase launched the Fed on the final policy course of the Alan Greenspan era. Most analysts predict that the central bank, wary of rising inflation, will boost rates in a series of quarter-point moves that could last for the next 18 months, lifting the fed funds rate to as high as 3% or 4%, a level that would be considered “neutral” -- neither stimulating nor discouraging economic growth.
Greenspan, the Fed’s chairman since 1987, is due to step down in January 2006.
The rate hike also was widely seen as bringing to a close one economic drama and beginning another.
Fed-engineered rate reductions of the last four years are credited with having carried the U.S. economy largely unscathed through a stock market bust, a spate of corporate corruption, a recession and a deadly terrorist attack.
The Fed’s new challenge is to wean the country off the lowest interest rates since the mid-1950s to protect against inflation, even while ensuring that the economy has the financial fuel it needs to keep growing.
The central bank’s policymaking Federal Open Market Committee illustrated the tricky balance it must strike in a statement accompanying its rate-hike decision.
As it has in the recent past, the statement said that the upside and downside risks to continued growth and low inflation were “roughly equal” and were likely to remain so for some time. It expressed continued confidence that the Fed could close out its cheap money policy “at a pace that is likely to be measured.”
But the Fed panel characterized the inflation danger in terms somewhat different from those in past statements, indicating that policymakers were growing ever so slightly more concerned about a pickup in prices.
Where the policymakers said last month that “long-term inflation expectations appear to have remained well contained,” their latest statement acknowledged that “incoming inflation data are somewhat elevated” and suggested that only a portion “appears to have been due to transitory factors” and is therefore of little worry. Transitory factors could include the recent surge in gasoline and other commodity prices, economists said.
The policymakers also added that they would “respond to changes in economic prospects as needed” to keep inflation low -- a statement that gives them flexibility to move more aggressively if price increases become more problematic.
“They’ve got to be concerned about how long it’s going to take them to move from an expansionary stance to neutral and whether inflation will pick up in the meantime,” said Stephen G. Cecchetti, a Brandeis University economist and former New York Federal Reserve Bank official.
As recently as December, an inflation measure favored by Greenspan was rising at a barely measurable 0.8% annual rate. But by May, it was climbing at a 1.6% pace.
The better-known core consumer price index -- which measures inflation excluding volatile food and energy prices -- rose at a 1.1% rate last year, but at a 2.9% pace in the first three months of this year. Fed officials have said they wanted to keep inflation in the 2% range.
Even with such worries, analysts said Greenspan and other policymakers appeared confident that they could hit the twin targets of continued growth and controlled inflation.
Already, the Fed has helped spur the economy to grow at about a 4% annual rate and to begin adding jobs again -- after failing to do so for nearly two years after the end of the 2001 recession. Nonfarm payrolls have expanded by 1.4 million since last August, according to the Labor Department. Forecasters predict that the job tally will climb by an additional 250,000 when the department releases June employment statistics Friday.
Despite the upward creep of inflation, Greenspan told a Senate hearing last month that inflation was “not likely to be a serious concern.”
“For the moment, they feel they’ve got this economy in the groove,” said David M. Jones, a Denver economic consultant and longtime Fed watcher. “They don’t think it can get much better than this.”
Investors reacted to the Fed decision by pushing stocks and bond prices up. The Dow Jones industrial average climbed 22.05 points, or 0.2%, to close at 10,435.48. Broader market indexes rose more sharply.
As bond prices rose, their market interest rates, which move in the opposite direction, fell. The yield on a bellwether 10-year U.S. Treasury note fell 0.11 percentage point to 4.58%. Analysts said that drop was a sign of relief that the Fed had not surprised the markets.
The leading presidential candidates used the Fed action to tout themselves and disparage opponents.
President Bush’s spokesman, Scott McClellan, said “the economy is strong and growing because of the policies the president put in place.... I think it’s always expected that a rate increase would be part of that strengthening of the economy.”
A spokesman for Democratic presidential contender Sen. John F. Kerry said it would be inappropriate for Kerry to comment on the Fed decision, then added that “the real issue is that George Bush’s abandonment of fiscal discipline will mean higher long-term interest rates, less sustainable economic growth and more debt.”
Fed actions during presidential campaign years are often controversial. The president’s father, former President George H. W. Bush, was widely reported to have blamed Greenspan for his 1992 election defeat, saying he did not cut interest rates fast enough to boost growth.
Greenspan-led Fed panels have raised rates during two elections, in 1988 and 2000.
The central bank cut the fed funds rate 13 times between January 2001 and May 2003, reducing it from 6.5% to a 46-year low of 1%. It then held the rate at 1% for a year to cushion the economy from the shocks of the stock bust and terror attacks, and to revive growth.
In addition to raising the funds rate a quarter-point Wednesday, the Fed also raised its largely symbolic discount rate, the interest it charges banks for short-term loans, by a quarter-point to 2.25%.
The next meeting of the Fed’s policymaking committee is scheduled for Aug. 10.
