Fed Stays the Course on Raising Key Interest Rate

Offering no letup in its fight against inflation, the Federal Reserve on Tuesday raised its benchmark short-term rate by a quarter-point for the 10th consecutive time and indicated that more hikes would be coming.

The central bank’s widely expected boost in its federal funds target rate, to a four-year high of 3.5%, renewed a debate about whether the Fed might become irrationally exuberant in its anti-inflation crusade.

Some investors and analysts contend that the central bank is overestimating the threat of inflation and could ultimately raise rates too high, slowing the economy unnecessarily. The Fed’s last cycle of credit tightening in 2000 led to a recession the year after, they say.

But the Fed on Tuesday indicated that it would have none of that soft-on-inflation talk. In its statement accompanying the rate announcement, the central bank’s Open Market Committee once again said it would continue to raise rates at a “measured” pace -- Fed-speak for more quarter-point boosts.

The Fed also acknowledged what recent economic data have made clear: Growth has gained momentum in recent months without a significant pickup in inflation.

“Aggregate spending, despite high energy prices, appears to have strengthened since last winter,” the Fed statement said. It added that although “core inflation has been relatively low in recent months ... pressures on inflation have stayed elevated.”

Analysts viewed the statement as further confirmation that the Fed wouldn’t quit tightening credit anytime soon. Many are now betting that the Fed will push its short-term target rate as high as 5%. Two months ago, the smart money thought 4% might be tops. The rate was 1% in June 2004.

“It is very hard to draw any conclusion other than that rates have some way further to rise,” said Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, N.Y.

Major banks immediately raised their prime lending rates by a quarter of a point to 6.5%. That will in turn elevate costs for variable-rate credit cards and some other consumer and business loans.

Yields on long-term bonds -- which have risen sharply in the last month on expectations of faster economic growth -- fell slightly Tuesday as traders were encouraged by the Fed’s benign comments on current inflation.

Stock investors’ reaction also was muted, with major indexes closing up for the day but near their levels when the Fed issued its statement less than two hours before the market close.

Clearly, some investors and analysts wish the Fed would take its rate-hiking ball and go home. Despite higher energy prices, they say, the economy is in a sweet spot: growing nicely without triggering too many inflation alarms.

Global competition is making it harder for companies to raise prices, they say. The economy is less dependent on energy and better able to absorb higher gasoline and natural gas prices. Slack remains in the labor market, with many discouraged people still out of the workforce.

“The probability of the Fed ‘overshooting’ and increasing interest rates more than necessary ... seems to be growing and is beginning to spook investors,” Bob Doll, chief investment officer at Merrill Lynch Investment Managers in New York, said in a report Monday. Rising interest rates, higher oil prices and a reviving dollar will soon begin to slow the economy, he said. So if the Fed raises above 4%, “we’d begin to get a little concerned,” Doll said Tuesday.

In the latest evidence on inflation, the Labor Department reported Tuesday that unit labor costs -- what employers pay for workers to produce a given amount of goods and services -- rose at an annual rate of 1.3% in the second quarter. That was down from 3.6% in the first quarter and below economists’ expectations of a 2.8% jump.

Over the last four quarters, however, unit labor costs have risen 4.3% -- the biggest increase since the year that ended with the second quarter of 2000. And growth in worker productivity -- a key factor in subduing inflation -- is slowing. Worker output per hour grew at a 2.2% annual pace in the second quarter, down from a 3.2% first-quarter gain, the Labor Department reported.

The rise in unit labor costs, amid slowing productivity, was cited as evidence justifying further Fed credit tightening.

“The economy is reaching close to full capacity,” said Lynn Reaser, chief economist with the investment strategies group at Bank of America Corp. in Boston. Notably, she said, the nation’s 5% unemployment rate is close to the 4.5% level now seen as representing full employment.

Also, interest rates remain relatively low, Reaser said. In 2000, the Fed boosted its benchmark rate to 6%.

Some analysts also have suggested that the Fed will keep raising rates to cool a housing market that Fed Chairman Alan Greenspan has called “frothy.”

But slowing the housing boom carries its own hazards, some say.

“The risk of bursting a possible residential real estate price bubble may deter the Fed from tightening more aggressively,” said John Lonski, chief economist at Moody’s Investors Service.

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Outlook for other interest rates

Here’s a look at where some key interest rates stand and the outlook in the wake of the Federal Reserve’s latest boost in its benchmark rate to 3.5% from 3.25%.

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Item: Prime lending rate

Current rate: 6.5%

Outlook: A number of major banks raised the prime a quarter-point Tuesday, matching the Federal Reserve’s rate increase. The prime, a benchmark for many consumer loans, usually changes immediately with Fed shifts. Next Fed meeting: Sept. 20.

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

Current rate: 2.73%

Outlook: Money fund yields usually track Fed rate changes, with a lag of six to eight weeks. The average money fund yield has risen 0.19 point since the Fed’s last quarter-point rate hike June 30.

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Item: One-year CD yield (U.S. average)

Current rate: 2.96%

Outlook: Certificate-of-deposit yields are expected to continue rising, but banks generally don’t raise their deposit rates as quickly as the Fed lifts its rate. The average one-year CD yield is up 0.13 point since the Fed’s June 30 meeting.

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Item: 10-year Treasury note yield

Current rate: 4.39%

Outlook: Bond rates are set by the marketplace, not by the Fed, and take their cue from the economy’s strength and the outlook for inflation. The 10-year T-note yield has jumped 0.47 point since June 30, and some analysts believe long-term yields will continue to edge up in the next few months if the economy remains strong.

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

Current rate: 5.82%

Outlook: Mortgage rates typically follow long-term bond yields but have risen more slowly than bonds recently. The 30-year mortgage rate is up 0.29 point since June 30.

Sources: Informa Research Services, IMoneyNet, Bloomberg News

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Text of the Fed’s Statement

Here is the Federal Reserve’s statement Tuesday on interest rates:

The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points [0.25 percentage point] to 3.5%.

The committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Aggregate spending, despite high energy prices, appears to have strengthened since late winter, and labor market conditions continue to improve gradually. Core inflation has been relatively low in recent months and longer-term inflation expectations remain well contained, but pressures on inflation have stayed elevated.

The committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.