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Central Bank Raises Key US Interest Rate - 2004-08-10

The U.S. central bank, the Federal Reserve, has raised a key short-term interest rate by .25 percent, the second such increase in less than two months. The Federal Reserve acknowledged recent weaknesses in the U.S. economy but reaffirmed its outlook for stronger expansion.

The modest quarter point rate hike in the so-called Federal Funds rate, which banks charge each other for overnight loans, was widely anticipated by economists and market-watchers. The rate now stands at 1.5 percent, half a point higher than the all-time low of one-percent that prevailed just six weeks ago, but still relatively low by historical standards. The Federal Funds rate stood above six percent as recently as 2001.

Economist Desmond Lachman of the Washington-based American Enterprise Institute says, just as important as the rate hike itself is the accompanying statement in which the Federal Reserve signaled its thinking for possible future action. The statement noted that "output growth has moderated and the pace of improvement in labor market conditions has slowed."

Last week, the Labor Department reported job creation was at a much slower pace than had been anticipated. Mr. Lachman says softness in the economy precludes aggressive interest rate hikes.

"The economy has not firmly begun growing at a rate that would make one worried about inflation," said Desmond Lachman. "There are a lot of downside risks to the growth outlook. So, the Fed [Federal Reserve] has, correctly in my view, taken the decision that they should be raising interest rates at a measured pace."

But the Federal Reserve also said that recent signs of economic weakness are largely attributable to soaring energy prices, which it described as "transitory", and that "the economy appears poised to resume a stronger pace of expansion going forward."

Desmond Lachman says the Federal Reserve must tread a fine line between raising rates too quickly, which could snuff out economic expansion, and not raising them quickly enough, which could cause the economy to overheat.

"Not raising them [interest rates] enough could result in inflation rising above what the Fed would like to see or what its longer term objective is," he said. "The difficulty of the decision the Fed had to make right now is that there are rather clear signs of softness in the economy that the Fed is acknowledging. But they are attributing this largely to the substantial rise in energy prices, and it seems to me they are taking the bet that energy prices are not going to be staying at this level for very long."

Mr. Lachman says the overall trend is toward higher interest rates in the United States, but at a slower pace than many economists had anticipated just a few months ago.

Rate increases in the United States generally spark interest rate hikes elsewhere as well, especially in countries that peg their currency to the dollar.