The Federal Open market Committee raised interest rates for the first time in two years, lifting the federal funds rate to 5.0 per cent from 4.75 per cent. It did not lift the discount rate and said it had shifted back to a neutral bias in its policymaking, indicating that it was agnostic as to whether the next move should be up or down.
"Owing to the uncertain resolution of the balance of conflicting forces in the economy going forward, the FOMC has chosen to adopt a directive that includes no predilection about near-term policy action," the Fed said. "The committee, none the less, recognises that in the current dynamic environment it must be especially alert to the emergence, or potential emergence, of inflationary forces that could undermine economic growth."
US stock markets rallied on the news, with the benchmark Dow Jones industrial index gaining 130 points to 10943.6. But Ian Shepherdson, of High Frequency Economics in New York, warned that the decision by traders on Wall Street to send shares soaring was a "knee jerk reaction".
He said the market was reacting to the Fed's decision to alter its bias from "tighten" to "neutral", adding: "Once the economists produce their views on it tomorrow it will all change."
He said all previous recent rate rises had been accompanied by a corresponding change in stance and that not too much should be read into it.
The decision to raise rates had been heavily signalled by the Fed for months in advance. The Fed lowered rates three times at the end of last year, after international economic crisis shook US financial markets. Since then, it has reassessed both domestic and international conditions and decided to revisit the decisions.
"Last fall the committee reduced interest rates to counter a significant seizing-up of financial markets in the US," said a statement from the Federal Open Market Committee. Since then much of the financial strain has eased, foreign economies have firmed, and economic activity in the US has moved forward at a brisk pace. Accordingly, the full degree of adjustment is judged no longer necessary."
The markets had been expecting a quarter point rise, but some analysts feared that a half-point rise might be on the agenda. The markets had been expecting the Fed to come back with further rises after the economic data for the first half of the year are in and the direction of the US economy becomes clearer. But the shift to a neutral bias reassured the market that the Fed might not raise rates in the near future.
The announcement leaves the Fed chairman Alan Greenspan with the maximum room for manoeuvre. It shows that the Fed is not reassessing the economy's direction in any fundamental way, but is making changes at the margin to its decisions last week.
The last increase in US interest rates was in 1997, but apart from this the Fed has been reducing rates for four years. Interest rates peaked at 6 per cent in February 1995 and stayed there for four months. The low point of interest rates in the last cycle was 3 per cent. The Fed has made 31 rate changes since July 1990, or about one every three to four months.
Low interest rates combined with a turnaround in US government finances, low energy prices and a strong dollar have helped to create America's benign combination of strong growth, low inflation and low unemployment.
A turnaround in the US economy would have devastating political effects for the Democrats' hope of maintaining control of the White House in next year's presidential election and perhaps take control of the House of Representatives. But US monetary policy is carried out independently of the government by the Fed, which is well-insulated from political pressure.
US growth in the first half of the year was about 4 per cent, and it had been expected to slow in the latter half of the year. But the Fed had indicated concerns about tightening labour markets and rising asset prices, and Mr Greenspan had told Congress that it was better to act pre- emptively than to await the arrival of inflation.
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