Fed Boosts Rates, Hints It May Pause

The Federal Reserve on Thursday raised its benchmark interest rate a quarter-point to 5.25% but appeared to leave open the possibility that it might pause its credit-tightening program at its next meeting.

The news cheered stock investors, who drove the Dow Jones industrial average up 217.24 points, or 2%, to 11,190.80, its largest point increase since March 2003. Bond yields and the dollar fell, additional signs of greater expectations for an end to Fed rate hikes.

But some analysts warned investors and consumers not to get their Fed-pause hopes too high, noting that inflation continues to run above the central bank’s comfort level. Economic data issued between now and the next Fed rate-setting meeting Aug. 8 would be crucial, they noted.

For the first time since the rate-hike cycle began in June 2004, the Fed’s statement following its action did not suggest it was leaning toward another increase.

Instead, the policymakers said, “The extent and timing of any additional firming that may be needed ... will depend on the evolution of the outlook for both inflation and economic growth.”

At its previous meeting May 10, the Fed said that further increases “may yet be needed” but that their “extent and timing ... will depend importantly on the evolution of the economic outlook.”

That subtle shift in language was interpreted by many analysts as the strongest sign yet that the Fed under new Chairman Ben S. Bernanke was not predisposed to further tightening.

Many analysts have argued about whether the Fed is on the verge of raising rates too high, risking a sharp economic slowdown or even a recession. They have noted that the housing market -- a key influence on consumer spending and confidence -- is already weakening significantly, in part because of previous Fed rate increases.

“There has been an outbreak of rationality at the Fed,” said Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, N.Y. “Payrolls permitting, they’re done.”

Shepherdson was referring to the possibility that the June jobs report, to be released July 7, will show further signs that the economy is losing steam.

The Fed’s credit tightening has been aimed at blunting inflationary pressures by slowing the economy to a “soft landing.” That is typically seen at a growth rate of about 3%, a more sustainable level than the revised 5.6% pace set in the first quarter, as reported by the Commerce Department on Thursday. That was the fastest expansion in more than two years.

Some observers believe the Fed’s policymaking committee should have held its benchmark federal funds rate at 5% amid evidence of slowing growth and signs that the economy has not yet felt the full effect of previous hikes. Bernanke himself has acknowledged that it could take as long as a year before previous rate increases cool the economy.

It’s not easy to get it right.

“The Fed has always overshot,” said Matthew J. Smith, portfolio manager with Smith Affiliated Capital in New York.

The Fed’s two-year campaign of persistent quarter-point hikes is unprecedented, he said.

In the past, the Fed has raised rates in bigger increments with longer intervals, taking time to gauge their effect.

This Fed’s tightening streak is unbroken, with Thursday’s boost its 17th in a row.

“They’ve never done this before,” Smith said. “So there’s a lot to be worried about in terms of risk going forward.”

There also is concern that the Fed is fighting a battle that it cannot win through rate hikes. Tightening credit is seen as an effective way of beating back inflation induced by rising wages.

But on the whole, U.S. workers’ wages have trailed inflation. Instead, inflation has been generated principally by high energy and commodity prices driven up largely by China’s growing consumption, a phenomenon beyond the Fed’s control.

Following the Fed action, many banks raised their prime lending rate by a quarter-point to 8.25%.

That in turn will boost rates on certain credit cards, home equity loans and other loans pegged to the prime, while pressuring mortgage rates upward.

The Fed’s statement Thursday included references to economic growth that supported the view that it may be finished raising rates.

In May, the Fed said growth was “likely to moderate to a more sustainable pace,” but on Thursday it said, “Economic growth is moderating.”

That amounts to a reversal, said Bob Walters, chief economist for Quicken Loans Inc., a mortgage lender.

“While the Fed didn’t assert that they are done with future rate increases,” he said, “this was the most positive statement since the rate increases began in 2004.”

However, others saw the rate-setting board as still hawkish.

“The Fed is giving itself maximum room to maneuver,” said Nariman Behravesh, chief economist with consulting firm Global Insight in Waltham, Mass. The firm is predicting a rate hike in August and total increases of up to three-quarters of a percentage point over the next six months.

For the next few months, Behravesh said, the Fed will remain in the uncomfortable position of confronting both slowing growth and rising inflation.

“While the growth slowdown is pretty much in line with what the Fed is expecting, core inflation is now above the central bank’s comfort zone, and Mr. Bernanke and Co. are trying to reestablish their credibility as inflation fighters,” he said. “In other words, when in doubt, they will hike.”

Behravesh said inflation-adjusted interest rates were still about 1 percentage point lower than levels that would be considered “tight” by most economists.

But according to Bernard Baumohl, executive director of the Economic Outlook Group in Princeton Junction, N.J., the Fed is not likely to push the rate beyond 5.5% because anything higher would jeopardize growth.

The Fed statement, he said, “did not rule out another increase. But it did suggest that the economy was clearly slowing and all that was left at this point is to see how quickly it will be followed by lower inflation.”

David Huether, chief economist with the National Assn. of Manufacturers in Washington, said the Fed already might have gone too far.

“With economic growth moderating, core inflation contained and monetary policy already more or less neutral,” the Fed’s action “could lead to slower economic growth in coming quarters,” Huether said.