MARKETS HAIL MILD ACTION ON INTEREST RATES; CENTRAL BANK SAYS IT WILL STAND PAT; STOCKS, BONDS SURGE.

Byline: Kimberly Blanton The Boston Globe

The Federal Reserve Board raised interest rates by a quarter-percentage point Wednesday, setting off rallies in the stock and bond markets with a surprise announcement that no further rate increases are planned in the near future.

The boost in the federal funds rate, from 4.75 percent to 5 percent, was a widely anticipated move to slow down the economy and to head off inflation by causing increases in interest rates on everything from credit cards to business loans. But the stock market, reacting with a mixture of relief and euphoria, soared 200 points within minutes after the Fed confirmed investors' expectations and then dropped its ``bias'' toward more rate hikes over the next few months. At the end of the day, the Dow Jones industrial average was up 155.45 points, closing at 10,907.80.

As recently as two weeks ago, Fed chairman Alan Greenspan expressed concern that the strong U.S. economy - sailing along in the second-longest boom in history - was in danger of triggering inflation in wages and prices. The Federal Open Market Committee, headed by Greenspan, explained its first rate hike in two years in a written statement. Sharp increases in U.S. workers' productivity have, for now, eased concerns about a tight labor market, the committee said, and have kept a lid on inflation.

Members cautioned, however, that they remain ``especially alert to the emergence, or potential emergence, of inflationary forces that could undermine economic growth.''

What surprised investors and economists who monitor every Fed move was a decision to withdraw its stance in favor of future rate hikes. At its previous meeting, the committee had announced a bias toward higher rates.

David Jones, a Fed watcher for Aubrey Lanston & Co. in New York, said the Fed's neutral stance on rates could jeopardize its ability to fight inflation. ``It was curious the Fed pulled back,'' Jones said. ``It means they're going to sit on the sidelines a while, but the danger is this could raise the possibly the economy could overheat.''

Despite the Fed's stated goal of heading off inflation, economists predicted such a gentle action would have only minimal impact on the economy and on consumer confidence, which is nearing levels not seen since the 1960s.

Banks foresee no slowing

Bankers from Connecticut to California said Wednesday that small businesses, the engines of economic growth, will continue to borrow at ``incredibly high'' levels despite the slightly higher rates.

The Fed typically boosts the federal funds rate - the rate at which commercial banks charge each other for overnight loans - in an attempt to curb spending by consumers and businesses, which must borrow to invest in new plant and equipment. Banks, in turn, raise the rates charged to their best customers - the prime rate. Fleet Financial Group, New England's largest commercial banking company, and other major banks immediately hiked their prime lending rates to 8 percent. Credit card interest, home mortgages and other rates typically follow suit.

Economists speculated that the committee acted cautiously because the bond market has done much of its work for it. Since the beginning of this year, yields on the benchmark 30-year U.S. Treasury bond have marched higher, rising from about 5.12 percent to a current range of 6 percent.

Higher mortgage rates, for example, were blamed for a recent dampening in home sales.

The bond market might have overreacted to anticipated Fed moves. Bonds rallied Wednesday, restoring some losses in their prices during the first half of the year. The 30-year Treasury bond's yield dropped Wednesday by almost 10 basis points to 5.96 percent; that is the first time it has closed below 6 percent since June 18. (Bond yields move in the opposite direction of prices.)

Reasons for optimism

Wednesday's rate increase was a first move to unwind three consecutive rate dips enacted last year - in September, October, and November - amid what the Fed Wednesday described as a ``significant seizing-up'' of U.S. and global financial markets triggered by collapsing currencies that cascaded from Asia to Russia and threatened South America.

Memories of the dramatic financial crises have been virtually erased by news that Japan's economy might be in a long-hoped-for recovery and that fragile Southeast Asian economies are also beginning to climb out of their rut.

The Fed, lauded for the remarkable feat of helping to rescue a troubled world economy, has turned its attention to a U.S. economy that is charging ahead - perhaps too quickly - in reaction to last year's rate decreases.

Greenspan faces a tricky task in navigating interest-rate policy through an economy that is expanding at a breakneck pace with virtually no signs of inflation, said William Cheney, economist for John Hancock Mutual Life Insurance Co. in Boston.

The Fed's decision to withdraw its bias toward further tightening is tantamount to ``Alan Greenspan admitting he's not God, and he doesn't know what he's going to do next,'' Cheney said. Future Fed decisions ``depend on what happens.''

More growth predicted

Indeed, economists said most indicators still point to a continued boom. Consumer confidence in June scored its eighth consecutive monthly gain, corporate profits are up, and inflation remains remarkably low. The index of leading indicators, which attempts to forecast future economic growth, gained 0.3 percent in May after decreasing slightly in April, the Conference Board said Wednesday.

But with unemployment rates at 30-year lows, the Federal Reserve believes there is a danger wages could go higher and spark inflation if workers' productivity gains taper off. Productivity has risen more than 2 percent in the past year.

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Chart

Chart: INTEREST RATES

The Federal Reserve raised the federal funds rate, a key short-term interest rate, by 0.25 percentage point Wednesday. Here is a look at the federal funds rate, the discount rate and the prime rate since 1990.

SOURCE: AP research

Associated Press