Fed Raises Key Interest Rate to 3%

The Federal Reserve continued its slow-motion campaign against inflation Tuesday, hiking its key short-term interest rate by another quarter point and signaling that it would not ease its effort to rein in rising prices even as it acknowledged that the economy was slowing.

As expected, the central bank raised the federal funds target rate to 3%. It was the Fed’s eighth hike since June, but it still leaves the rate near zero when matched against the ever-climbing pace of inflation, which has risen to 3.1% over the last year.

The increase in the funds rate -- what banks charge each other on overnight loans -- led major banks to raise their prime lending rates to 6% from 5.75%. The prime, a benchmark for many business and consumer loan rates, now is the highest since September 2001.

But mortgage rates, influenced by longer-term bond yields, have been easing recently. The average 30-year fixed home loan rate is 5.78%, according to mortgage firm Freddie Mac.

While the Fed has tripled its short-term rate since June, mortgage rates have dropped nearly 0.5 percentage point since then, a divergence that Fed Chairman Alan Greenspan has termed a “conundrum.�

Some analysts, however, suggest that lower long-term bond yields reflect investors’ belief that a slowing economy is more likely than rising inflation.

In its statement Tuesday, the Fed retained its language that it would continue to hike rates at a “measured� pace, but also noted that “pressures on inflation� continued to rise. The Fed also acknowledged the economic slowdown in the first quarter, which some analysts said was an indication that future rate hikes would continue to be modest.

Stocks zigzagged after the news, then rallied in the final minutes of trading after the Fed announced that it had inadvertently left out from its statement a sentence it had included in previous recent statements, that “Longer-term inflation expectations remain well contained.�

The Fed’s late correction to its statement helped to quickly lift the Dow Jones industrial average from a loss of about 44 points to end the day up 5.25 points at 10,256.95. Bond yields fell on the news of the revision.

As usual after a Fed announcement, analysts carefully scrutinized every sentence. Veteran Fed-watcher David Jones said this was the first time in his memory that the central bank had gone back and revised its statement. The addition of its reassurance on inflation, Jones said, showed that the Fed was concerned about the slowdown.

“The fact that they went through all this trouble to release it says to me that Greenspan does not want to put as much emphasis on inflation as some in the market would,� said Jones, chief executive of DMJ Advisors in Denver. “The new surprise to the Fed is the unexpected softness in the economy in the first quarter, and while the Fed hopes that will be reversed with a rebound later, that’s the one thing they’re unsure of.�

Others focused on the central bank dropping its previously issued reassurance that high energy prices were not leaking into core inflation. They said the new communique showed the Fed’s top priority was keeping inflation in check.

“It’s blindingly obvious that inflation is at the top of the agenda,� said Ian Shepherdson, chief economist at High Frequency Economics in Valhalla, N.Y. “This is a signal that they’re going to keep going unless the sky falls in on the growth front.�

Some economists believe that could happen. First-quarter growth clocked in at an annual rate of 3.1%, the government announced last week, well below expectations although still in line with historical averages. Some forecasters believe growth could slow even further as rising gasoline prices continue to take a bite out of consumer spending, presenting the Fed with a challenge: taming inflation while not damaging the economic recovery.

When the Fed raises interest rates to quash inflation, it increases many consumer and business borrowing costs, thereby slowing economic growth.

“What does the central bank do when their growth goal is compromised and their inflation goal is compromised at the same time?� asked Allen Sinai, head of Decision Economics in New York. “Hopefully, we’re not stuck with that choice, but increasingly it looks like we’re going to sacrifice some growth in the name of maintaining inflation in a low range.�

Jones, of DMJ Advisors, believes that if the economy continues to soften, the Fed could halt its hikes later this year when its benchmark reaches 3.5% or 3.75%, in line with expectations of the bond futures market. The Fed is expected to boost rates another quarter point at its next meeting June 28-29.

Others see the economy remaining strong and the Fed staying committed to a steady march of quarter-point rate hikes.

“They’ve got the economy right where they want it,� said David Wyss, chief economist at Standard & Poor’s in New York. “They’re happy to see the economy slow down -- they just don’t want it to slow down too much.�

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(BEGIN TEXT OF INFOBOX)

The Fed’s Statement

Text of 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%.

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. Recent data suggest that the solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices. Labor market conditions, however, apparently continue to improve gradually. Pressures on inflation have picked up in recent months, and pricing power is more evident. Longer-term inflation expectations remain well contained.

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.

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(BEGIN TEXT OF INFOBOX)

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 from 2.75% to 3%.

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Item: Prime lending rate

Current rate: 6%

Outlook: Major banks usually raise the prime lending rate in tandem with Fed shifts, and many did so Tuesday, lifting their rate from 5.75% to 6%. The prime is a benchmark for many consumer loans, such as home equity credit lines.

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

Current rate: 2.25%

Outlook: Money fund yields typically track Fed rate changes, with a lag of six to eight weeks before a rate change is fully reflected. The average fund yield has risen 0.27 point since the Fed’s last quarter-point rate hike on March 22.

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Item: Six-month CD yield (U.S. average)

Current rate: 2.21%

Outlook: Certificate-of-deposit rates have been rising at a steady pace since last summer. They are expected to continue heading gradually higher if the Fed keeps pushing its key rate up.

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Item: 10-year Treasury note yield

Current rate: 4.17%

Outlook: Signs of a slowing economy have pushed long-term bond yields lower since early April, despite expectations that the Fed would continue to raise short-term rates. Long-term interest rates are set by the marketplace rather than by the Fed, and are influenced primarily by the economy’s strength and by inflation trends. Lower bond yields suggest that many investors expect a weaker economy and don’t believe inflation will get out of hand.

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

Current rate: 5.78%

Outlook: Mortgage rates generally follow bond yields. The average 30-year home loan rate has fallen from a recent peak of 6.04% the week ended April 1 and is well below the 2004 peak of 6.34% reached last May.

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Graphics reporting by Tom Petruno

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Sources: Informa Research Services, ImoneyNet Inc., Freddie Mac, Bloomberg News