July 1, 2004

Federal Reserve Raises Key Rate a Quarter Point

WASHINGTON, June 30 — The Federal Reserve raised its benchmark interest rate on Wednesday for the first time in four years, officially signaling that a remarkable period of historically low rates is drawing to a close.

But even as it increased the cost of borrowing for financial institutions on overnight loans to 1.25 percent from 1 percent, it sought to soothe investors by saying that inflationary pressures remained low and that further rate increases should come at a "measured" pace.

The Fed's statement was a relief for many on Wall Street, as well as for home buyers, who will be able to get mortgages at comparatively low rates for at least a few more months.

It also appears to be good news for President Bush. Even though the Fed is expected to keep increasing interest rates as the November elections approach, the economic impact of those increases is likely to be mild until at least sometime next year.

But some of the Fed's growing chorus of critics on Wall Street warned that the Fed's chairman, Alan Greenspan, might have waited too long to start raising rates. That could force the central bank to play catch-up in tightening monetary policy in the months ahead to prevent inflation from re-emerging as a serious economic threat.

For now, though, any rate increases are likely to be mild. Mortgage rates, which had already climbed noticeably in anticipation of the Fed's decision, may not rise appreciably in the days ahead. Because Mr. Greenspan and other top officials had telegraphed their intentions months in advance, yields on long-term Treasury securities, which directly affect mortgage rates, actually declined slightly after the Fed's announcement.

The stock market also took the move in stride, with the Dow Jones industrial average closing at 10,435.48, up just more than 22 points.

"This was exactly what they had advertised, and I think the markets were reassured," said Stuart G. Hoffman, an economist at PNC Financial in Pittsburgh.

Both President Bush and Senator John Kerry of Massachusetts, the presumptive Democratic nominee for president, reacted cautiously to the Fed's announcement.

Scott McClellan, Mr. Bush's spokesman, said the rate increase merely reflected the economy's strength. "As the economy grows and jobs are being created," he said, "I think it's always expected that a rate increase would be part of that strengthening in the economy."

Mr. Kerry's campaign refrained from commenting on the central bank's decision, but accused Mr. Bush of setting the stage for higher interest rates in the future by allowing the federal budget deficit to swell.

"Over the long term," said Gene Sperling, a top economic adviser to Mr. Kerry, "economists estimate that Bush's fiscal policies would raise long-term interest rates by about 1 percentage point higher, meaning that a typical family would have to pay $1,200 more for a home mortgage each year and $120 more for a student loan each year."

"The higher debt passed on to our children and the higher long-term interest costs working families and American businesses will bear amount to a Bush debt tax that will require a new economic strategy," Mr. Sperling added.

Mr. Greenspan, a Republican, has himself warned that rising federal deficits will ultimately contribute to higher interest rates and could pose a threat to the nation's long-term economic health.

But Mr. Greenspan's immediate preoccupation is to be on guard for signs of rising inflation. Echoing those recent statements, the central bank left itself ample room to apply tougher economic medicine if those signs multiply.

"They are buying themselves flexibility," said Laurence H. Meyer, a former Fed governor and now president of Macroeconomic Advisers, an economic forecasting firm in St. Louis. "They are saying, `We will go at a measured pace unless we don't.' "

In devising what it hopes is a gradual retreat from the easy-money policies of the last several years, the Fed is striving for what policy makers used to call a "soft landing." The goal is to head off a resurgence of inflationary pressures without provoking financial disruptions or an economic downturn.

The remarkably low interest rates of recent years, which fell to a level not seen since the late 1950's, reflected Mr. Greenspan's determination to ward off the shocks to the economy caused by recession, terrorist attacks and the war in Iraq. But economic growth started to surge last summer, and job creation finally began to accelerate this spring.

Investors had assumed for months that the Fed would announce a quarter-point rate increase on Wednesday, at the end of its two-day policy meeting. Fed officials have made it clear that this will be the start of a series of regular rate increases that could easily last through the end of 2005.

The big question now is how fast that process will proceed and how far it will go. The primary factors are likely to be the pace of consumer price increases in the months ahead and the speed at which unemployment declines.

Mr. Greenspan's goal, though he has never officially stated it, has been to keep the underlying inflation rate, excluding volatile areas like food and energy, under about 2 percent a year but not so low that it threatens to turn to actual deflation, or falling prices.

Fed officials were clearly startled when the core inflation rate climbed at an annual rate of more than 3 percent in March and April, but many officials contended that the fundamental trend was more sedate.

The central bank reiterated that view in its statement on Wednesday. "Although incoming inflation data are somewhat elevated, a portion of the increase in recent months appears to have been due to transitory factors," the Fed said.

Fed officials still want to see the unemployment rate decline from its current level of 5.6 percent. Even though the United States has added nearly 1.4 million jobs since last August, that is still barely half the number of jobs lost since the start of 2001.

Fed officials have long asserted that the economy still has considerable slack in the form of unemployed workers and unused factory capacity. But its statement Wednesday omitted any reference to economic slack. Jan Hatzius, an economist at Goldman Sachs, said that was "not a surprise but nonetheless an indication that the committee is a bit more concerned than they were" about inflationary pressures.

In contrast to its practice in 1994, when the central bank raised rates much more abruptly than investors had been expecting, Fed officials have been telegraphing the arrival of higher rates for months.

After its policy meeting in January, the central bank dropped its open-ended commitment to keep interest rates low for "a considerable period" and said instead that it would be "patient." In May, the Fed implied that rate increases were imminent but said the pace was "likely to be measured."

Indeed, the yield on 10-year Treasury notes climbed by nearly a full percentage point in April and May. Mortgage rates climbed noticeably, as well, leading immediately to a sharp decline in home refinancings and producing a slight cooling effect in some housing markets.

Fed officials were openly pleased, contending that the markets had already begun to do much of their job for them in advance.

"I think the Fed had to lay the groundwork because of the very ugly experience of 1994, when they did not prepare the groundwork," said Gregory R. Valliere, an economist at Schwab Soundview Capital Markets in Washington. "They really wanted to avoid catching the markets off balance."

Many economists predict that the so-called measured pace of rate increases means a long series of baby steps, generally a quarter-point at a time, that would eventually lift the federal funds rate from its current level of 1.25 percent to more than 4 percent by the end of 2005.

But that plan could be disrupted if inflation continues to climb faster than expected.

Mr. Greenspan and other top Fed officials have warned that they will ratchet up the pace of rate increases if their own prediction of mild inflation appears to be wrong.

"Our general view is that inflationary pressures are not likely to be a concern in the period ahead," Mr. Greenspan told the Senate Banking Committee on June 15. But "forecasts are subject to error," he added. "And if our judgment as to how the economy is going to evolve and how inflation is going to evolve turns out to be mistaken, we will change."

Josh Feinman, an economist at Deutsche Asset Management in New York, said that the Fed had given itself some wiggle room. "They think they will be able to move in this gradual, measured way," he said. "But a zillion things could happen that they can't anticipate, and they need to stand ready. They don't want to say anything that constrains their ability to act in the future."