Rates rise in US as inflation 'picks up'

Greenspan maintains 'measured' approach with seventh consecutive increase - Oil prices still a threat

Issuing a clear warning of increasing inflationary pressures, the Federal Reserve yesterday nudged its key short-term interest rate higher for the seventh straight time. The news sent Wall Street and long-term bond prices tumbling, but boosted the dollar as traders predicted that further and larger rate hikes lie ahead.

Issuing a clear warning of increasing inflationary pressures, the Federal Reserve yesterday nudged its key short-term interest rate higher for the seventh straight time. The news sent Wall Street and long-term bond prices tumbling, but boosted the dollar as traders predicted that further and larger rate hikes lie ahead.

In a widely anticipated move, the rate-setting Federal Open Market Committee (FOMC) raised its target rate for federal funds to 2.75 per cent from 2.5 per cent - the latest 25 basis point increase since the central bank began boosting rates last June from an historic 45-year low. Less expected, however, was the FOMC statement's language on inflation.

Inflationary pressures had "picked up" in recent months, it said, noting that fast-rising energy prices had not yet fed through into core consumer prices. But contrary to many expectations the committee - headed by Alan Greenspan, the Federal Reserve chairman - kept its all-important phraseology of "measured pace" to describe its preferred strategy of rate changes.

In response to the Fed's move, the Dow, which had been 40 points up before the announcement, was almost 100 points down at the close. Long-term bond yields, unusually low in recent months, also climbed, following the inflation warning.

"In a mild way, the Fed is showing its teeth," Alan Blinder, the former vice-chairman of the central bank, said. Further rate increases of 0.25 per cent were most likely, "but it's conceivable that after this they could do 50 points".

Though the US economy is on course to expand by a solid 3 to 3.5 per cent in 2005, surging deficits and the growing threat of inflation are casting an increasing shadow over monetary policy-making here.

The closely watched wholesale price index rose 0.4 per cent in February, the biggest jump in three months, the Labor Department announced separately yesterday. Though the increase was almost wholly due to energy and food costs - with the so-called core rate of inflation virtually unchanged - the Fed has been put on alert.

Core producer prices have climbed 2.8 per cent in 12 months, the biggest year-on-year advance since November 1995. Without falls in the price of new cars, the core index too would have risen an alarming 0.4 per cent. This month alone has seen US petrol prices rise 10 per cent. Even so they do not reflect the latest surge in the cost of oil, which reached $57 (£30) earlier this week - nor has the summer driving season, when demand is highest, yet begun.

The other worry for the Fed is the weak dollar, reflecting international concern at the massive US trade and federal budget deficits. Ahead of the meeting, the battered currency perked up as traders drew comfort from Joseph Yam, head of the Hong Kong Monetary Authority, who warned that financial markets would be shaken if foreign central banks diversified too rapidly from dollars. The Fed's move drove the dollar up against sterling and the euro by more than a cent.

But the issue remains sensitive, given that the dollar needs to attract almost $1.8bn a day in foreign currency inflows to finance its current account deficit, running at $650bn annually - nearly 6 per cent of GDP. The bulk of the buying has been by central banks, mainly in Asia, with purchases of US government securities.

For that reason, analysts say, the Fed will probably keep pushing rates higher, to make dollar investments more attractive.