Fed Boosts Interest Rate, Raises Specter of Inflation

The Federal Reserve hiked interest rates Tuesday and rattled investors by warning about rising inflation pressures, marking the first time in more than four years that the central bank has openly worried that prices might be climbing too quickly.

The Fed’s shift raised the prospect that interest rates could be headed significantly higher this year, which in turn could slow the economy -- and particularly the still-booming housing market.

Nervous investors drove the Dow Jones industrial average to its lowest close since late January, while interest rates on long-term Treasury bonds surged to their highest levels since June. Mortgage rates tend to follow bond rates.

At its regularly scheduled meeting Tuesday, the Fed lifted its key short-term interest rate by a quarter-point, to 2.75% -- the seventh such increase since June. The move had been anticipated as the central bank brings interest costs back into line with the growing economy.

In a surprise, however, policymakers said in their post-meeting statement that “pressures on inflation have picked up in recent months” and that “pricing power is more evident,” meaning that some businesses have been better able to boost prices of goods and services.

Concerns about higher inflation haven’t appeared in a Fed statement since November 2000. In its previous statement after its Feb. 2 meeting, the Fed simply referred to inflation as being “well contained.”

On Wall Street, which is alert to every nuance in Fed utterances, the new wording was widely viewed as a warning that the central bank might begin raising interest rates more aggressively, which could put the brakes on consumer and business spending.

“The Fed is very explicitly concerned about inflation expectations,” said Amitabh Arora, an interest rate strategist at brokerage Lehman Bros. in New York. “The only thing in their armory to contain those inflation pressures is short-term interest rates.”

The Fed’s stance is a dramatic turnabout from two years ago, when policymakers were worried about a lack of inflation. Then, they feared that the economy faced a greater risk of a debilitating deflation, or declining prices, similar to what ravaged Japan in the 1990s.

That was the main reason the Fed slashed its benchmark rate to a generational low of 1% in 2003 and kept it there until last June. But with the rebound in the global economy over the last two years, deflation worries have dissipated. Last year, surging prices for oil and other commodities began to raise the specter of worrisome inflation.

For consumers coping with record prices at the gas pump, soaring new-home costs and higher prices for some imported goods because of the weakened dollar, the Fed’s acknowledgment of growing inflation risks might seem anticlimactic.

“The whiff of inflation has been picked up by a lot of people” already, said Tad Rivelle, chief investment officer at money management firm Metropolitan West Asset Management in Los Angeles.

Fed policymakers, however, focus on the broad trend in prices in the economy, not just on the most visible.

Indeed, in its statement Tuesday, the Fed seemed to downplay the surge in oil costs over the last year, saying that the “the rise in energy prices ... has not notably fed through to core consumer prices,” referring to a measure of inflation that excludes volatile energy and food costs.

But that dismissal of energy’s effects on inflation reinforced the notion that the Fed was worried about price pressures emerging from other sources, analysts said.

Overall, inflation remains far from the double-digit levels of the late 1970s and early 1980s. Yet the Fed -- and financial markets -- are haunted by memories of that era and how it ravaged the economy and eroded the value of stocks and bonds. That is why the threat of accelerating inflation makes policymakers, and many investors, so nervous.

The consumer price index, the government’s main inflation gauge, rose 3.3% in 2004, the biggest jump in four years, as gasoline prices leapt. Without energy and food costs, the so-called core CPI was up a more modest 2.2% for the year, but that still was double the 1.1% core rate of 2003.

The government today is expected to issue its report on the CPI for February.

In speeches in recent months, some Fed governors have expressed nervousness about inflation pressures. But economists look to the Fed’s statement after its policymaking meetings -- held every six to eight weeks -- for the official stance.

The Fed altered other wording in its statement Tuesday that appeared calculated to send a message about inflation risks and the outlook for interest rates, analysts said.

Since June, policymakers have pledged to tighten credit at a “measured” pace, which has come to mean a quarter-point increase at each meeting.

The Fed maintained the “measured” pledge. But the statement also said that, “with appropriate monetary policy action,” the balance between “sustainable growth” in the economy and stable inflation “should be kept roughly equal.”

That “appropriate policy” condition didn’t appear in the Fed’s previous statement.

The change is a strong hint that the Fed is prepared to raise rates at future meetings by a half-point, instead of a quarter-point, if inflation concerns mount, said Kathy Bostjancic, an economist at brokerage Merrill Lynch & Co. in New York.

She called the Fed’s language change “hawkish spin” on inflation and interest rates.

At a minimum, the Fed’s warning could mean that it will continue to raise its benchmark rate for a longer period than Wall Street had expected, some analysts said.

“Those who thought that the Fed would be stopping soon will have to change their view,” said Ken Kim, an economist at Stone & McCarthy Research in Skillman, N.J.

Of course, with the Fed’s key rate at 2.75%, even a two-percentage-point increase would leave the rate well below the 6.5% it reached in 2000.

But many analysts have questioned whether the U.S. economy, despite its rebound over the last two years, could handle significantly higher interest rates.

A major concern is that consumers have borrowed aggressively in recent years to maintain their spending. Each tick higher in the Fed’s rate means higher debt payments for many people.

The central bank’s rate, the so-called federal funds rate, is the overnight loan rate among banks. By changing that rate, the Fed influences other interest rates, such as banks’ prime lending rate, which determines the going rate on many floating-rate consumer loans.

Major banks raised the prime a quarter-point Tuesday, to 5.75%, in tandem with the Fed.

The biggest wild card could be the housing market. If Wall Street drives rates on Treasury bonds and other securities higher, anticipating that the Fed might tighten credit at a faster pace, red-hot home sales -- and prices -- could finally face a serious slowdown, analysts warn.

The housing sector has been a huge source of support for the economy, and record prices have bolstered the net worth of millions of Americans, in turn underpinning their spending.

“For me it comes down to the housing market,” said Jan Hatzius, an economist at brokerage Goldman Sachs & Co. in New York. “What happens to the boom in house prices as interest rates move up?”

The nationwide average rate on 30-year fixed-rate mortgages was at an eight-month high of 5.95% last week, according to mortgage finance company Freddie Mac in Washington. With the jump in Treasury bond yields this week, the mortgage rate is likely to top 6% soon.

“It’s been some time since the consumer has been looking at a 30-year rate in the 6% range,” said Anthony Hsieh, president of online mortgage broker LendingTree. “We’ll have to see if this slows the housing market down.”

With the Fed’s warning Tuesday, he said, “Certainly the cost of borrowing is not coming down.”

Times staff writer Annette Haddad contributed to this report.