Fed Raises Key Interest Rate to 2.5%
The Federal Reserve on Wednesday raised its key short-term interest rate by a quarter-point for the sixth time since June, and signaled that it remained on a steady credit-tightening course.
The Fed’s policymaking Open Market Committee said it had voted to lift its benchmark short-term rate to 2.5% from 2.25%, putting the rate at its highest level since October 2001.
The move, which had been considered a virtual certainty, will push up some consumer borrowing costs but also will mean more interest income for savers, who are already enjoying the highest yields in three years.
On Wall Street, the stock market posted its sixth gain in seven sessions, which some analysts said reflected confidence in the Fed’s well-telegraphed plan of slowly lifting rates from generational lows.
“They really want the market to know” what they’re doing, said Sean Flannery, an investment strategist at State Street Global Advisors in Boston. “This way, there isn’t a lot of second-guessing.”
The Fed’s relatively candid approach has helped stock prices move higher -- and long-term bond yields decline -- even as the central bank has raised its key rate from 1% in June, Flannery said.
The Dow Jones industrial average gained 44.85 points, or 0.4%, to 10,596.79 on Wednesday, continuing to rebound after sliding in the first three weeks of the year. Long-term Treasury bond yields were unchanged from Tuesday.
The wording of the central bank’s statement after its meeting was nearly identical to the one it issued after its last gathering, on Dec. 14. Included was the now-familiar reference to tightening credit “at a pace that is likely to be measured” -- which Wall Street views as code for a quarter-point rate increase at each Fed meeting.
Policymakers also reiterated that they viewed inflation as being “well contained.”
With little change in the economic backdrop since mid-December, many analysts said it made no sense for the Fed to do anything but affirm what the world already knows: that Chairman Alan Greenspan and his peers believe they can gradually lift rates to more normal levels as the economy expands.
The Fed would need “consistent evidence of slowing economic growth before it changes its current posture,” said Asha Bangalore, an economist at Northern Trust Co. in Chicago.
Fed watchers almost unanimously expect the central bank to order at least two more quarter-point rate hikes, one at its March 22 meeting and another at its May 3 gathering, according to a Reuters poll Wednesday of economists. That would bring the target benchmark rate -- the so-called federal funds rate, an overnight loan rate among banks -- to 3%.
The Fed had slashed the rate from 6.5% in 2000 to 1% by mid-2003 to help the economy, which had been battered by the Sept. 11, 2001, terrorist attacks, a recession and the stock market’s dramatic plunge.
But by early last year Fed officials were warning that they could no longer justify rock-bottom interest rates as the economy recovered.
Now, most analysts believe the Fed will continue raising its key rate until it becomes “neutral” -- neither stimulative nor depressive to the economy. But there is no consensus on Wall Street as to what the neutral rate might be.
David Rosenberg, an economist at Merrill Lynch & Co. in New York, believes the central bank will stop at 3.25%. State Street’s Flannery expects the Fed to go to at least 4%. Michael Darda, an economist at MKM Partners in Greenwich, Conn., said the neutral rate could be as low as 3.5% or as high as 4.5%.
The number is likely to be a moving target, depending on the economy’s growth, inflation, gains in productivity and other factors, experts say.
Economists hope to get a better sense of the Fed’s views when Greenspan testifies before Congress on Feb. 16 and 17.
In the meantime, some borrowers should expect to pay more this year as banks’ prime lending rate rises in tandem with the Fed’s key rate. Many major banks, including Bank of America Corp., Wells Fargo & Co. and Comerica Inc., boosted the prime to 5.5% from 5.25% on Wednesday.
The prime, which has jumped from 4% in June, is used as a base rate for many business and consumer loans, such as home equity credit lines.
Savers, meanwhile, can expect to see yields continue to rise on money market mutual funds and bank certificates of deposit.
The average seven-day yield on money market funds stood at 1.75% on Wednesday, up from 1.68% a week earlier and the highest since December 2001, according to rate tracker IMoneyNet Inc. in Westborough, Mass. The yield was 0.54% in mid-June, before the Fed’s first rate hike.
The average yield on one-year bank CDs nationwide is 2.17%, up from 2.15% a week ago and up from 1.45% in mid-June, according to Informa Research Services in Calabasas.
Many analysts advise savers to be wary of locking in current yields on longer-term bank CDs, such as two-year maturities, as long as the Fed continues to push up its benchmark rate. Until the Fed stops, those yields are likely to continue rising, said Greg McBride, an analyst at Bankrate.com in New York.
He said savers also should shop around for the highest CD yields. Because every bank has the same federal deposit insurance, “you can get additional return without taking more risk,” McBride noted.
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Text of Fed’s Statement
From Reuters
Here is the statement from Federal Reserve policymakers Wednesday:
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 2.5%.
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. Output appears to be growing at a moderate pace despite the rise in energy prices, and labor market conditions continue to improve gradually. Inflation and longer-term inflation expectations remain well contained.
The committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal. With underlying inflation expected to be relatively low, 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.
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Outlook for key interest rates
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Item: Prime lending rate
Current rate: 5.50%
Outlook: Major banks raised the prime a quarter point Wednesday, matching the Federal Reserve’s rate increase. The prime, a benchmark for many consumer loans, usually changes in tandem with Fed shifts. The next Fed meeting: March 22.
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Item: Money market mutual fund average yield (seven day)
Current rate: 1.75%
Outlook: Money fund yields usually track Fed rate changes, with a lag of six to eight weeks. The average money fund yield has risen 0.25 point since the Fed’s last quarter-point rate hike Dec. 14.
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Item: Six-month CD yield (U.S. average)
Current rate: 1.78%
Outlook: Certificate of deposit yields rose slowly when the Fed began lifting short-term rates in June, but are advancing more quickly now. The average six-month CD yield is up 0.21 point since Dec. 14.
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Item: 10-year Treasury note yield
Current rate: 4.14%
Outlook: Bond rates are set by the marketplace, not by the Fed. Long-term bond yields are little changed since the Fed’s last meeting. Yields have remained steady in part because investors trust that inflation won’t surge, analysts say.
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Item: 30-year mortgage rate (Freddie Mac average)
Current rate: 5.66%
Outlook: Mortgage rates generally follow long-term bond yields. The 30-year mortgage rate is down from 5.68% when the Fed met in December.
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Graphics reporting by Tom Petruno.
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Sources: Informa Research Services, IMoneyNet Inc., Bloomberg News
