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Friday, June 30, 2006 - Page updated at 12:00 AM

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Fed raises interest rates to 5.25 percent, fuels hopes for pause

MarketWatch

WASHINGTON — The Federal Reserve raised a key interest rate Thursday by a quarter percentage point to 5.25 percent as expected, and signaled that further rate increases would depend on the outlook for inflation and growth.

U.S. stock markets had their best one-day gain in three years after the central bank's closely watched statement renewed hopes that inflation would be contained without higher rates or a collapse in growth, but economists warned that it's too early for the Fed to declare victory over inflation.

The statement from the Federal Open Market Committee (FOMC) gingerly balanced the risks of higher inflation against factors that should limit price gains, including high productivity, the housing slowdown and the lagged effects of past rate increases. But "some inflation risks remain," even as "economic growth is moderating," the FOMC said.

The Fed has increased rates at 17 straight meetings since June 2004, bringing its target federal-funds rate from a four-decade low of 1 percent to 5.25 percent, the highest level since March 2001. The vote was unanimous.

"The Fed has moved into the zone of maximum discretion," said Brian Bethune, U.S. economist for Global Insight. "They can do whatever they like."

"It's too early in the game to be declaring victory," said Ethan Harris, chief U.S. economist for Lehman Bros. "They are saying the same thing they've been saying: inflation risks remain, and additional firming may be needed."

The statement hinted that more rate increases could be coming, but there were no guarantees.

"The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information," the committee wrote. The new language replaced previous wording that said "some further policy firming may yet be needed."

Financial-futures markets scaled back their expectations for future rate increases. The market sees one more rate increase this year, likely in August.

The FOMC's statement acknowledged the obvious on both inflation and growth, Lehman's Harris said. "Readings on core inflation have been elevated in recent months," the FOMC said. "Economic growth is moderating."

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Much of the rest of the language in the statement the future course of growth and inflation will matter, not the past.

The rate increase was widely expected after hawkish commentary over the past six weeks from Fed officials, especially Fed Chairman Ben Bernanke.

Many economists and the market predict the Fed could be done after one more move to 5.5 percent in August. But a growing number of Fed watchers have been raising their expectations of the year-end rate to 6 percent.

Reaction among economists ranged from hawkish to dovish.

A quarter-point rate increase in August is baked in the cake, said Citigroup Global Markets chief U.S. equity strategist Tobias Levkovich.

Although they changed the language, "the intent is basically the same. They are still thinking about the need for further tightening," said Dan Seto, an economist for Sumitomo Mitsui Asset Management.

"There is a little nuance that we are even closer to the end," said Kurt Karl, an economist for Swiss Re.

After the economy expanded at a 5.6 percent rate in the first quarter, economists expect gross domestic product growth to slow abruptly to a 2.9 percent pace in the April-June quarter.

The big question is what happens to the growth rate in the second half of the year. Private-sector forecasters now peg third-quarter growth at 2.9 percent, and the fourth-quarter at 2.8 percent.

The Fed sees growth slowing, and that should help bring down inflation. "Although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the committee judges that some inflation risks remain," the statement said.

Bernanke will deliver the committee's official forecast in three weeks during congressional testimony.

For now, the committee's statement will have to do: "Recent indicators suggest that economic growth is moderating from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of interest rates and energy prices."

High productivity has kept unit labor costs down and "inflation expectations remain contained," the committee said. However, high levels of resource usage and high commodity prices have the potential to keep inflation pressures up, the FOMC said.

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