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Fed raises rates, citing inflation pressure

Federal Reserve policy makers on Tuesday tightened US borrowing costs in line with expectations but spooked Wall Street with an aggressive warning on inflation.

With the world's biggest economy picking up pace, the Federal Open Market Committee (FOMC) lifted the benchmark federal funds rate by 25 basis points -- for the seventh time in as many meetings -- to 2.75 percent.

In a statement, the FOMC under Fed Chairman Alan Greenspan retained its use of the soothing terms "measured" and "accommodative" to describe its probable future course of action.

But the statement also packed a punch that caught investors off guard.

"Though longer-term inflation expectations remain well contained, pressures on inflation have picked up in recent months and pricing power is more evident," it said.

On Wall Street, the dollar strengthened against major currencies, long-term borrowing rates shot up and the stock market weakened on the Fed's warning. Both the Dow Jones and NASDAQ averages closed down nearly 1 percent.

Merrill Lynch chief economist David Rosenberg said the Fed had taken a "half step towards a more aggressive move on the interest rate front."

"The Fed has not signalled a 50 basis point move at either of its next meetings, but certainly is willing to make a move if inflation does not stay contained," he said.

The FOMC met just after news that US wholesale prices rose 0.4 percent last month, led by a surge in energy prices. The core rate for the producer price index, which excludes volatile food and energy costs, went up 0.1 percent.

The markets have taken comfort in the fact that strong US PPI numbers have not yet fed into rising consumer prices, the sharp end of inflation. Intense competition, especially in the jobs market, has kept inflation moderate.

But with higher oil prices feeding into record-breaking gas pump prices for US drivers, the Fed may be growing anxious about the impact on consumer inflation further down the line. Rising energy prices could in turn act as a brake on growth. But the economy has so far shrugged off higher crude prices, helped by billions of dollars in tax cuts by the administration.

The US economy posted annualized growth of 3.8 percent in the fourth quarter of last year, and official projections for this year target healthy growth of 3.5 to 4 percent.

The FOMC dropped its talk of moderate growth but cited instead a "solid pace" of expansion. It said that with "appropriate" monetary policy action, risks to sustainable growth and price stability should be kept in balance in the US.

"Nonetheless, the committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability," it added.

The markets started betting on a more bellicose stance from the Fed at its next meeting in May, with some predicting the end of "measured" rate hikes and forecasting the federal funds rate will hit at least 4 percent by year-end.
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