The move had been widely expected as a pre-emptive strike against over-rapid economic expansion and inflation. After a meeting of the policy-making Federal Open Market Committee, the Fed announced the discount rate, at which it lends to commercial banks, would rise from 3.5 to 4 per cent, while the federal funds target rate, at which banks lend money to each other, would go up to 4.75 per cent from 4.25 per cent. Both rates are at their highest level since December 1991.
Within half an hour Chase Manhattan became the first big bank to raise its prime rate, by half a point to 7.75 per cent. Other banks followed suit. Consumers and businesses are likely to be affected by the Fed move, through overdraft, credit card and perhaps mortgage- rate increases.
In a statement, the central bank said it moved 'to keep inflationary pressures contained and thereby foster sustainable economic growth'. Barring an unexpected spurt in either prices or economic growth, however, it signalled that the rises would be the last for a while. They were expected 'to be sufficient . . . to meet the objective of sustained, non-inflationary growth'.
The increases were steeper than the quarter-point boost that some analysts had expected, after a number of strong economic statistics recently. They won an initial vote of confidence on Wall Street, where stocks jumped 18 points after the news. By closing,the Dow had risen by 24.28 points to 3784.57.
After the announcement the benchmark 30-year Treasury bond climbed strongly to close up 121 32 , sending its yield down to 7.37 per cent and demonstrating the market's conviction that controlling inflation remains the top priority of Alan Greenspan, the Fed's chairman. The dollar was broadly unchanged on the London close at DM1.5550 after an initial gain was erased by profit-taking.
The most recent US price data have been mixed: a worrying jump of 0.5 per cent in wholesale prices in July (the worst performance in 15 months), followed by a more modest rise of 0.3 per cent in retail prices for the same month, bringing year- on-year consumer inflation to 2.7 per cent. But in congressional testimony last week, Mr Greenspan made clear he would rather push rates too high than hold them too low, allowing inflation to gather steam. Overall, the latest move has nudged Fed policy from neutral to slightly restrictive.
Emboldening the central bank was the knowledge that the four earlier rate increases of 1994, which pushed the fed funds rate from 3 to 4.25 per cent, have not markedly slowed the economy. Provisional second-quarter GDP grew by 3.7 per cent, marginally up from the 3.4 per cent growth in the first quarter, and confounding widespread predictions of a slowdown. In July, the economy created 259,000 new jobs, exceeding most expectations on Wall Street.
Yesterday brought further confirmation of the recovery's vigour: a 0.2 per cent jump in industrial output in July, the 14th straight monthly increase, and a near-5 per cent boost in housing starts last month - proof that the rise in mortgage rates since last October's low has not severely damaged the important construction sector.
Although higher interest rates carry a political risk to the Clinton White House - already facing big losses in this autumn's mid-term elections - the administration has voiced little public objection. Indeed, they could have the advantage of strengthening the dollar and helping reverse the outflow of funds that so damaged the bond and stock markets earlier this year.
View from City Road, page 27