Banking & Capital Markets

Surprise! Fed Hikes Short-Term Rates

The widely expected boost is expected to be the start of a lengthy upward trend.
Stephen TaubJuly 1, 2004

It’s the end of an era. After more than two decades and four presidents, the Federal Reserve Bank is apparently embarking on a tightening mode.

On Wednesday, in a widely-anticipated move, the central bank’s Federal Open Market Committee (FOMC) raised its target for the federal funds rate by 25 basis points, to 1.25 percent.

In a related move, the Fed approved a 25-basis-point increase in the discount rate, to 2.25 percent. The discount rate is the interest rate that banks pay on short-term loans from a Federal Reserve bank.

The boost in the federal funds rate on overnight loans is widely expected to be the start of a long trend of rate hikes. To be sure, the Fed has raised rates in the past. Indeed, a series of hikes in the mid-1990s temporarily sent the global bond markets into a free-fall. But yesterday’s increase is clearly different. That’s because, after hitting an historic low of 1 percent, short-term interest rates have nowhere to go but up.

Even so, the Fed left itself enough elbow room to keep rates low for some time. “The committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity,” the Fed stated.

Output is continuing to expand at a solid pace and labor market conditions have improved, according to the Fed’s statement. And although incoming inflation data are somewhat high, it made a point of noting, “a portion of the increase in recent months appears to have been due to transitory factors.”

Because inflation is expected to remain relatively low, Fed policies to accommodate it can be removed at a pace that is likely to be measured, the committee said. Translation: Rates will rise in small, quarter-point increments rather than a half-point at a time.

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