WASHINGTON - Federal Reserve officials yesterday raised two key short-term interest rates and indicated that they will refrain from further credit tightening for a while to see how the economy responds.
The Clinton Administration responded by witholding judgement of the Fed's action, but said it remained optimistic that the economy will continue to expand at a healthy pace while inflation remains in check.
Following a four-hour meeting, members of the Federal Open Market Committee announced an increase in the federal funds rate to 4.25% from 3.75 %. The action marked the fourth time this year that Fed policymakers saw a need to raise short-term rates.
But the latest move was a holder stroke than the earlier increases of 25 basis points, which elicited criticism from some market participants that the Fed was acting too timidly to rein in the threat of higher inflation in a headstrong economy.
In addition, the Federal Reserve Board voted 5 to 0 to raise the discount rate to 3.5% from 3%. The largely symbolic move, which affects the rate that the Fed charges banks for overnight loans, underscored the central bank's shift to a tougher stance on rates. It was the first increase in the discount rate since Feb. 24, 1989, when the rate was raised to 7% from 6.5%, a Fed spokesman said.
The bond market soared in reaction yesterday as investors concluded that the central bank will pause to assess its handiwork before pushing rates any higher. In afternoon trading, the yield on the 30-year Treasury bond plunged to 7.29% from 7.45%.
"This gives the market an opportunity to stabilize," said Darwin Beck, director for CS First Boston. "The market essentially got what it wanted and responded positively."
Commercial banks responded quickly by announcing increases in the prime lending rate to 7.25% from 6.75%. The rate increases, the second this year, will automatically translate into increased borrowing costs for home owners and businesses with loans tied to the prime.
Federal Reserve Chairman Alan Greenspan and his colleagues on the FOMC have been saying since the beginning of the year that they wished to lift short-term rates to achieve neutrality in monetary policy. They never defined what level they meant, other than to mean some increase in the federal funds rate above the rate of inflation.
In a press release yesterday, Fed officials said that the latest increase in short-term rates combined with the earlier rate hikes "substantially remove the degree of monetary accomodation which prevailed throughout 1993."
Analysts took that statement to mean that officials believe they have largely completed the short-term objective of achieving a "neutral" monetary policy that is no longer contributing to rapid economic growth with low rates. More rate increases could be forthcoming, but not until the July 5-6 meeting of the FOMC, said Beck.
The positive reaction in the bond market also reflected the belief that the central bank was not afraid to fight inflation by tightening rates, analysts said.
"This allows the Fed to take the high ground, to say that they are being relatively aggressive and staying well ahead of the inflation risks," said Dana Johnson, head of market analysis for the First National Bank of Chicago. "This is definitely being accepted an an action that keeps the Fed's credibility high."
Johnson said there is no question that Fed officials are seeking to slow the pace of economic growth to a sustainable, long-term rate that does not fuel inflation - generally a range of 2.5% to 3% in the view of most economists. But the aim is not to kill the expansion, he said.
"This is designed to allow the expansion to be well behaved and continue for a long time," said Johnson. "Expansions don't die of old age. They die from the Fed fighting inflation because the expansion gets too vigorous."
Clinton Administration officials continued to withhold critism of the Fed for raising short-term rates. "The administration respects the independence of the Federal Reserve and neither criticizes nor endorses its actions," said Laura D. Tyson, head of the president's Council of Economic Advisers. "It is the prerogative of the Federal Reserve to adjust monetary policy to serve the goal of sustained expansion with low inflation."
President Clinton, interviewed by reporters as the FOMC meeting got under way, seemed to say he would not oppose another credit tightening by the Fed. "There is clearly some room for short-term interest rates over the rate of inflation that won't slow down our economic growth," Clinton said.
Clinton predicted: "We will be able to offset any modest increase in interest rates with increased growth." Tyson, in her statement, said the administration remains confident that, "the economy is on a path of sustained growth, strong employment creation, and low inflation."
Administration officials have said they understand that the Fed is seeking to crimp growth a little, but they also are hopeful that by acting now officials will preempt a surge in inflation that would trigger much higher rates and run the risk of snuffing out the expansion