However, few expect the near-100 point sell-off that occurred on Wall Street on Friday evening to turn into a crash.
The increase in the rate the Fed charges banks for overnight funds brought the race towards the 4000 level on the Dow Jones Industrial index to an abrupt halt.
The New York stock exchange was obliged to impose trading halts to limit the sell- off, which saw the Dow Jones Industrial Average plunge 96.24 points to 3,871.42 - a fall of 2.4 per cent. Short-term interest rates rose, but so did longer rates, surprising many traders.
The increase in the Funds rate to 3.25 per cent caught financial markets off-guard, as did the manner in which it was executed. In an unprecedented move, the Fed chairman, Alan Greenspan - who had hinted at a tightening last Monday - announced the decision at the end of a closed two-day meeting of the Board's Open Market Committee.
Mr Greenspan's announcement on Friday morning was followed by a dollars 1.5bn customer repurchase agreement confirming the new 3.25 per cent rate.
'A little bit of medicine now means we'll avoid much worse later,' said John Williams, chief economist at Bankers Trust and a former Fed governor.
Low interest rates have been a major force behind the bull run in world equity markets. They have helped to drive savings out of alternative investments into shares and provided a substantial boost to corporate performance.
Market strategists say the increase could force share prices down 5 per cent over the next month. But few predicted this modest increase alone would trigger the 10 per cent 'correction' that some on Wall Street have been forecasting.
Some market players said the Fed's increase should be interpreted as an indication of its confidence in the growth of the economy and in corporate profits. 'One tightening won't stop a bull market,' said David Shulman, chief market strategist at Salomon Brothers in New York and one of Wall Street's more pessimistic voices in recent months.
Indeed there is also a good chance many will see a correction as a buying opportunity, says Elaine Garzarelli, the Lehman Brothers analyst who predicted the 1987 and 1989 crashes.
Most economists believe the Fed's action will leave the downward drift in European interest rates unaffected. Provided that the mark does not weaken sharply against the dollar, analysts predict the Bundesbank should be ready to cut rates later this month or early next, clearing the way for lower rates in Britain and elsewhere in Europe.
Gavyn Davies, chief economist at Goldman Sachs, said: 'Some people will say the Fed decision is timely, pre-empting higher inflation, and is therefore good for equities.'
Peter Oppenheimer, international investment strategist at James Capel, added that in the past, 'if the Fed raises interest rates before inflationary pressures pick up, then that tends to imply the right signals to the financial markets - that inflation will remain stable - and that is obviously a positive backdrop for the equity markets.
'The most important thing for the UK is that, on average, the UK market has always risen for two years after that tightening.'
Julian Jessop, of Midland Montagu, said: 'The downside for Europe is limited, and if US long-term rates do indeed fall faster as a result of increased Fed credibility, long-term rates in Europe will also benefit.'
However, Chris Turner, currency analyst at BZW, warned: 'In the currency markets I think we will see a lasting move; and this is the move I think the dollar really needed to push it higher.'
On the equity front, a new paper by Goldman Sachs argues that a Fed tightening will leave equities relatively unscathed because shares will outperform bonds in a period of earnings growth and because equities are partially discounting higher rates.
Jeremy Warner, page 2
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