Interest rate increase first in four years

Thursday, July 1, 2004

Federal Reserve officials Wednesday raised a key short-term interest rate for the first time in four years and signaled that they will keep moving it up in coming months as aggressively as necessary to keep inflation under control.

Fed policymakers concluded a two-day meeting by lifting their target for the Federal funds rate to 1.25 percent from 1 percent, where it had been for the last year.

The officials, in a statement issued after the meeting, acknowledged that inflation had picked up recently but attributed part of that trend to temporary factors. They also said that they expect "underlying inflation," which excludes volatile food and energy prices, to remain "relatively low." Thus if inflation remains tame, the Fed can raise its target "at a pace that is likely to be measured," said the statement issued by the Fed's top policymaking committee, repeating a phrase that has implied small rate increases -- of a quarter-percentage point at a time -- spread over many months.

But the committee also emphasized that it is prepared to abandon that plan if its forecasts prove wrong, saying it "will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability."

The statement effectively warned financial markets that the Fed was making no promises about the path of interest rates, and that it must have flexibility to respond appropriately to changing conditions in an economy still in transition from a wobbly recovery to a sustained expansion.

Financial markets had little reaction to the Fed's action, reflecting the apparent success of the policymakers' recent efforts to telegraph their intentions and thinking. Stock and bond prices rose slightly after the statement was released.

The rate increase is expected to immediately boost costs for home equity lines of credit, variable-rate credit cards and some other personal loans. Nearly all of those loans are tied to the prime rate, which moves in near lock step with the Fed's benchmark overnight lending rate for banks.

Still, the balances on these loans generally are low enough to make Wednesday's move appear insignificant.

At Wells Fargo Bank, for example, the average outstanding balance on a home equity credit line is $40,000, said Doreen Woo Ho, president of Wells Fargo Bank's consumer credit group. A quarter-point increase will cost the average borrower about $8 a month, she said.

Credit card terms vary widely, but with the average individual credit card debt less than $8,000, experts don't see the quarter-point hike as a significant factor.

The biggest effect could be on home buyers. The cost of home mortgages started rising in March in anticipation of the Fed's move, which had been telegraphed to investors for months. That makes it more costly to buy a house.

Mortgage rates have been rising for months. The average 30-year fixed-rate reached 6.25 percent last week, up from its low this year at 5.38 percent in March, according to mortgage financier Freddie Mac. Wall Street economists generally forecast the rate to reach 6.6 percent by the end of the year, and 6.7 percent by June of next year, according to a survey released Tuesday by the Bond Market Association.

Banks, on the other hand, are likely to respond to the Fed action Wednesday by raising their prime lending rate for business loans to 4.25 percent from 4 percent, and by continuing to move it up in coming months with each increase in the Fed funds rate.

The Fed is raising rates not to slow the economy, but rather to ensure that it does not grow so rapidly that inflation takes off.

At 1.25 percent, the target remains extremely low and should continue to stimulate economic growth, but just a little more lightly than it did at 1 percent, economists said. Thus the Fed's action is more like lifting a little pressure off the economy's accelerator than like touching the brakes.

Higher borrowing costs tend to restrain household and business spending, which helps keep the lid on inflation in a rapidly growing economy. Lower rates tend to encourage spending, which helps spur economic growth.

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