The Fed coupled its first rate hike in nine years with a signal that further increases will likely be made slowly as the economy strengthens further and inflation rises from undesirably low levels.
Wednesday’s action signaled the central bank’s belief that the economy has finally regained enough strength 6½ years after the Great Recession ended to withstand modestly higher borrowing rates.
“The Fed’s decision today reflects our confidence in the U.S. economy,” Chair Janet Yellen said at a news conference.
The Fed said in a statement after its latest meeting that it was lifting its key rate by a quarter-point to a range of 0.25 percent to 0.5 percent. Its move ends an extraordinary seven-year period of near-zero borrowing rates. But the Fed’s statement suggested that rates would remain historically low well into the future, saying it expects “only gradual increases.”
“The Fed reaffirmed that the pace of rate hikes would be slow,” James Marple, senior economist at TD Economics wrote in a research note. “The Fed’s expectations for rate hikes next year are set alongside a relatively cautious and entirely achievable economic outlook.”
Stocks closed up sharply higher. The Dow Jones industrial average, which had been up modestly before the announcement, gained 224 points, or 1.3 percent, for the day.
The bond market didn’t react much. The yield on the 10-year Treasury note rose slightly to 2.29 percent.
Rates on mortgages and car loans aren’t expected to rise much soon. The Fed’s benchmark rate doesn’t directly affect them. Long-term mortgages, for example, tend to track 10-year U.S. Treasury yields, which will likely stay low as long as inflation does and investors keep buying Treasurys.
But rates on some other loans, like credit cards and home equity credit lines, will likely rise, though probably only slightly as long as the Fed’s rate hikes remain modest.
Shortly after the Fed’s announcement, major banks began announcing that they were raising their prime lending rate from 3.25 percent to 3.50 percent. The prime rate is a benchmark for some types of consumer loans such as home equity loans. Wells Fargo was the first bank to announce the rate hike.
Among other things, the Fed’s low-interest rate policies have helped jump-start auto sales, which are on track to reach a record 17.5 million this year. And the Fed’s first hike may not slow them.
Steven Szakaly, chief economist for the National Automobile Dealers Association, says dealers will press financing companies to keep loan rates low. And competition for buyers will spur them to take other steps to hold down rates, such as accepting lower profits.
“The rate squeeze will happen between the dealer and its finance company rather than the dealer and the consumers,” Szakaly said. “Consumers won’t even feel it.”
For months, Yellen and other Fed officials have said they expected any rate hikes to be small and gradual. But nervous investors have been looking for further assurances.
Yellen indicated that Wednesday’s rate hike was partially defensive. If rates stayed at near zero, the Fed might not have the tools to combat a recession.
“We’ve worried about the fact that with interest rates at zero, we have less scope to respond to negative shocks,” she said at her news conference.
When growth struggles, the Fed often cuts rates to help increase the amount of cash flowing through the economy. But by staying close to zero, the Fed would be unable to cut rates or it would be forced to have negative rates for the first time in its history.
An updated economic forecast released with the policy statement showed that Fed officials predict that their target for the federal funds rate—the rate that banks charge on overnight loans—will end next year slightly above 1 percent. That is in line with the consensus view of economists.
The Fed’s action was approved by a unanimous vote of 10-0, giving Yellen a victory in achieving consensus.
The statement struck a generally more upbeat tone in its assessment of the economy. It cited “considerable improvement” in the job market. And it expressed more confidence that inflation, which has been running well below the Fed’s 2 percent target, would begin rising. It suggested this would happen as the effects of declines in energy and import prices fade and the job market strengthens further.
In addition to the funds rate, the Fed is raising three other rates: It lifted the interest it pays on the reserves that banks hold at the Fed to 0.5 percent from 0.25 percent. It raised the rate it pays on a type of short-term loan to 0.25 percent from 0.05 percent. The Fed plans to use those two rates to help meet its new higher target for the funds rate.
In addition, it announced a quarter-point increase in its discount borrowing rate to 1 percent from 0.75 percent. This is the rate banks pay when they borrow emergency loans from the central bank. This rate typically moves up in conjunction with the Fed’s benchmark rate.