Federal Reserve policy-makers nudged interest rates up a quarter-point yesterday, a move that surprised virtually no one and that many economists believe will allow America's good fortunes to keep rolling.
By increasing rates for the second time in eight weeks, the central bank hopes to keep inflation benign and avoid a credit-tightening severe enough to end the U.S. economic party.
"People think higher interest rates are bad," said Carl Tannenbaum, chief economist for ABN Amro in Chicago.
"But in this case, the Federal Reserve is sacrificing near-term strength for long-term length."
Yesterday's quarter-point increase in the so-called federal funds rate to 5.25 percent -- the highest since September 1998 -- came after a scheduled meeting of the central bank's policy-making Federal Open Market Committee (FOMC).
The federal funds rate, also known as the "overnight rate," is what banks charge each other for overnight loans. It is an important benchmark for interest rates and is the same rate the Fed boosted a quarter-point after its last meeting, June 30.
The FOMC also lifted the largely symbolic discount rate by a quarter-point to 4.75 percent yesterday, an action economists feel was meant to underscore the commitment of the central bank to fighting inflation.
But the Fed committee signaled that it wasn't predisposed toward another rate increase anytime soon. The FOMC next meets Oct. 5, though it can announce a rate shift at any time.
"Today's increase in the federal funds rate, coupled with the policy action in June and the firming of conditions more generally in the U.S. financial markets over recent months, should markedly diminish the risk of rising inflation going forward," a Fed statement said.
Higher interest rates essentially make money more expensive: Consumers and corporations theoretically borrow less and spend less, dampening the demand that can force prices upward.
Despite a moderate rise in prices -- 2.2 percent so far this year -- Federal Reserve Chairman Alan Greenspan, an inflation hawk, has expressed concern that tight labor markets are forcing employers to pay more to fill positions. That can be inflationary because it can prompt companies to raise prices and also gives people extra money to spend.
By increasing rates slightly now, Greenspan believes he can throttle back the U.S. growth engine and avoid more extreme increases later if a vexing cycle of inflation takes hold.
Consumers will feel the impact of the Fed's action in higher interest rates for credit cards, auto, home equity and other consumer loans, which typically are tied to the prime rate. BankOne Corp., First Union Corp. and Wells Fargo Bank NA -- the country's fifth- , sixth- and seventh-largest banks -- boosted their prime lending rates by a quarter-point to 8.25 percent yesterday afternoon.
But homebuyers will likely find little change in rates for fixed mortgages, which already have risen over the past two months.
The stock market appeared to take yesterday's rate increase in stride. The Dow Jones industrial average, which on Monday had surged more than 199 points to a record close in anticipation of a modest boost, turned volatile after the afternoon announcement. But by the 4 p.m. close, it had settled back to a 16.46 point loss, ending at 11,283.30. The technology-focused Nasdaq composite index rose 32.80 points to end the day at 2,753.37.
Economic and stock market experts say Greenspan has become masterful at managing the expectations of the financial markets by telegraphing his intentions to investors -- a skill of increasing importance with many stocks greatly overvalued.
During testimony before Congress last month, Greenspan said the Fed would act "promptly and forcefully" to raise rates if new economic data indicated that prices were on the rise.
After that appearance, reports showed that the economy created 310,000 jobs in July, 50 percent more than economists had expected. Workers' average hourly earnings rose more than predicted. And the employment cost index, the government's broadest measure of compensation, increased 1.1 percent in the second quarter, the fastest rise since 1991.
Sung Won Sohn, chief economist for Wells Fargo & Co. in Minneapolis, says these numbers show an inflation resurgence that could easily shock stocks into a steep-enough drop to dry up consumer spending.
"Despite what the Fed says about the diminished risk of inflation going forward, I think there is still risk that the economy is going to be too strong and that inflation and interest rates are going to be edging up," Sohn said.
ABN Amro's Tannenbaum believes that there's less risk of that happening. He sees growth continuing for some time, but notes that whatever ultimately derails the economy will likely be unforeseen.
Whenever his company's clients fondly recall the "quaint" days of the 1950s, and contend that was the best shape the country has ever been in, Tannenbaum often replies: "Pinch yourself every now and then to make sure [the current economy] is real. This may be the best set of economic circumstances we'll ever see."
Wire reports contributed to this article.