Federal Reserve policy-makers boosted short-term interest rates yesterday by half a percentage point, to their highest level in nine years, an aggressive move central bankers hope will hold off inflation and slow the most prosperous economy in U.S. history.
The rate increase takes the Federal Reserve's overnight lending rate to 6.5 percent, a level not seen since January 1991.
Yesterday was the sixth time since June 30 that the Fed had raised rates, and the first time since February 1995 that the central bank resorted to a half-point rate hike. It is only the fourth time since 1917 that the Federal Reserve has increased interest rates six times in a row at its policy committee meetings.
The overnight lending rate - also known as the federal funds rate - is what banks in the Federal Reserve System charge one another for overnight loans. The Fed also raised its more-symbolic discount rate on loans to banks by a half percentage point to 6 percent.
The rate increases will be felt by millions of borrowers. Several banks quickly announced half-point increases in their prime rate - the interest rate that banks charge their best customers and one that serves as a key benchmark against which many other loan rates are set.
First Union Corp., Bank of America Corp. and Bank One Corp. were among lenders announcing that their prime rates would rise from 9 percent to 9.5 percent, effective today. The last time the prime rate rose this high was Jan. 2, 1991, right before the current record expansion took wing.
Consumers will likely see the effect on shorter-term loans: home equity credit lines, car loans and credit cards with floating interest rates. Mortgages are influenced more by long-term interest rates, such as those set by the bond market.
After weeks of reports that have repeatedly illustrated the economy's strength, the Fed's more aggressive stance had been widely expected. In fact, economists say more rate increases could be in the offing in the central bank's effort to slow consumer spending - and therefore the pace of growth and inflation.
In the afternoon statement announcing its decision to boost rates, the policy-making Federal Open Market Committee, headed by Fed Chairman Alan Greenspan, said the risk of inflation lingers.
"Greenspan has another bullet in the chamber - and he's willing to use it," said Richard Yamarone, chief economist for Argus Research in New York.
After some temporary angst, investors reacted favorably to the Fed's decision. Stocks, which had been higher all morning, surrendered most of their gains right after the 2:15 p.m. announcement, but then turned north again and soared. The Dow Jones Industrial Average rose 126.79 points, or 1.17 percent, to close at 10,934.57. The Nasdaq composite index climbed 109.92 points, or 3.05 percent, to finish the trading day at 3,717.57.
Investors realize that, with an economy growing at better than a 5 percent clip, "the Fed has got the luxury of being able to move aggressively," said Mario DeRose, a bond-market strategist with brokerage house Edward Jones in St. Louis. "Even if they slow growth a little, it will still be fairly strong."
Influential stock market strategist Abby Joseph Cohen of Goldman, Sachs & Co. was similarly reassuring. At a conference in Washington just blocks from the Fed meeting, Cohen said the Fed's efforts to hold off inflation and slow growth to a more-reasonable pace will end up "elongating, not ending, the economic expansion."
Economic growth in the nation has topped 5 percent in each of the past three quarters - or 2 percentage points faster than central bankers have historically said is sustainable without spawning inflation. There hasn't been three straight quarters of such strong growth since 1983-1984.
Although Greenspan began his campaign to slow the economy and forestall inflation nearly a year ago, there hasn't really been any evidence that prices are rising - until recently.
Government reports of the past several months showed an uptick in inflation in February and March, although the Consumer Price Index report released yesterday by the Labor Department said that this important gauge was unchanged last month.
The closely watched "core" rate of the CPI, which excludes food and energy prices, increased 0.2 percent for April - just half the 0.4 percent rise reported a month earlier. Even so, the overall CPI is on a pace to rise 4.3 percent this year - a rate that, if sustained, would be the biggest consumer-price increase since 1990.
Economic reports such as these will help the Fed decide if, and how much more, interest rates will have to rise. Most economists say that Greenspan - despite his avowed independence from the political process - will want to conclude his interest-rate campaign long before the November presidential election. That way, there will be no talk of the central bank trying to influence the outcome of the election, economists say.
"It will be just this shot in the arm, and finish up by August, which will take them out of the election process," said Kevin Flanagan, an economist with Morgan Stanley Dean Witter in New York City.
But this self-imposed deadline to finish its interest-rate campaign could make for difficult decisions in June and August, when the Fed policy-makers meet again. Economists hope the Fed doesn't become overly bold and inadvertently raise rates too much and too soon, which could slam on the economic brakes and cause the economy to skid into recession.
"I think it's either an extremely clever move - or a mistake," said Argus Research's Yamarone. "[Greenspan] runs the risk of being too bold, and triggering a recession in early 2001."
In its statement, the Fed did not reveal what it plans to do at its next meeting, June 27 and 28. The current expansion has been unusual because of the strong productivity gains, which have helped keep inflation at bay. When productivity is rising, companies do not need to raise prices to cover higher production levels, but the Fed noted that demand still exceeds production.
"The committee is concerned that this disparity in the growth of demand and potential supply will continue" and spur inflation, the Fed said.