Bank stocks leaped higher after the Federal Reserve's Open Market Committee lifted the federal funds and discount rates 25 basis points on Tuesday, but some observers remained skeptical that the hike would be the final one.
The Fed voted to raise the federal funds rate, the overnight loan rate between banks, to 5.25%, and the discount rate, which it charges banks for loans, to 4.75%, and said it is maintaining a neutral stance on the need for further increases.
The Standard & Poor's bank stock index, which had been off, jumped 10 points to 679 shortly after the 2:15 p.m. announcement. It closed up 1.83 points, or 0.27% for the day, indicating most investors were satisfied that banks will not face further hikes. The Dow Jones industrial average fell 16.46 points, or 0.15%, to close at 11,283.30.
Tuesday's actions "should markedly diminish the risk of rising inflation going forward," the Fed said in its written statement.
But "that is more of a wish than an expectation," said Sung Won Sohn, senior vice president and chief economist at Wells Fargo & Co. in Minneapolis. "There is no evidence that the underlying economic conditions have been cooling since the Fed began to raise interest rates" in June.
Mr. Sohn noted several signs of possible inflation, including July payroll gains of 310,000 and a 0.5% increase in average hourly earnings. What's more, he said, the employment cost index rose 1.1% in the second quarter.
David Littman, chief economist at Comerica Inc. in Detroit, said commodity prices are rising and the dollar is weakening, making raw materials abroad more expensive, and oil prices have topped $21 a barrel.
"All the good news of the past two years is over because the import price windfall is gone," Mr. Littman said. "There is no longer a restraint on domestic pricing power."
Mr. Littman also noted that the M2 money supply, which is made of cash, time deposits, and checking accounts, has expanded annually at 8%. That will have to be tempered by more rate hikes by next year.
"There is too much money chasing too few goods," Mr. Littman said. "You will have a upward ratcheting effect of interest rates."
Though bank stocks gained on Tuesday after the news, the Fed's action may have the opposite effect in the coming sessions, said David Jones, chief economist at bond dealer Aubrey Lanston & Co. The Standard & Poor's bank stock index increased 30.66 points to 680.62 the five trading days through Monday.
"Banks were starting to rally a lot," Mr. Jones said. "This will set them back a lot, because it seems the Fed is more restraint minded than anticipated."
Prospects for a sustained rally in bank stocks seemed dim to some observers.
"The risks of a recession appear to be somewhat closer on the horizon, which is not a happy prospect," said Robert G. Hottensen, a managing director at Goldman Sachs Group Inc. in New York. But he said bank stock prices already reflect the rate hike, and that the industry's long-term prospects are good, thanks to consolidation and the opportunity banks now have to exploit the Internet.
The most significant implication of a hike in interest rates for banks is that it increases the cost of capital, said Henry C. Dickson, an analyst for Salomon Smith Barney, a Citigroup Inc. subsidiary in New York. For each 1% change in the cost of capital, bank valuations change 5%, he said.
"The market has built in a higher cost of capital as well as very modest growth expectations," said Mr. Dickson. "Right now it looks to us as if most banks have factored in a 100-plus basis point increase in the projections."
The action Tuesday was the second hike this year. The Fed raised the federal funds rate 25 basis points on June 30.
It left open the question of whether this year would be more like 1997, when a single 25-basis-point hike was deemed sufficient to hold inflation in check, or 1994, when the Fed jacked up short term rates by 300 basis points.
"The key question is not whether it will take 25 or 75 basis points," said Jonathan E. Gray, an analyst at Sanford C. Bernstein & Co. in New York. "The question is whether we are at the foothills of a mountainous rise in interest rates in the years to come."
Dan Weil contributed to this report.