With the rate hike, its third this year, the central bank thus removed the last of the extra liquidity it added to the money supply a year ago, when conditions in financial markets seemed so bleak as a panic swept the globe.
"Although cost pressures appear generally contained, risks to sustainable growth persist," the Federal Open Market Committee said in a statement released after its meeting.
"Despite tentative evidence of a slowing in certain interest-sensitive sectors of the economy and of accelerating productivity, the expansion of activity continues in excess of the economy's growth potential," the statement said.
The FOMC said tight labor markets had reduced the number of available workers, "a trend that must be eventually contained if inflationary imbalances are to remain in check and economic expansion continue."
The increase initially dampened enthusiasm in the stock and bond markets, although not dramatically. The yield on the 30-year Treasury rose to 6.06 percent. Stocks hesitated, then resumed their rally. The Nasdaq and S&P 500 hit records while the Dow crawled back close to 11,000.
"The Fed did what it should have done," said Irwin Kellner, chief economist at CBS.MarketWatch.com and the Weller professor of economics at Hofstra University. Read Kellner's column on Fed-watching.
The announcement gave a glimmer of hope that the boost in interest rates could be the last for a while: The three hikes and the ensuing higher interest rates in the market "should markedly diminish the risk of inflation going forward," the FOMC said. The committee also reverted to a symmetrical or neutral policy directive.
The increase of 25 basis points was matched almost immediately by top money center banks raising their prime rate and eventually will be reflected in most other market interest rates, from corporate borrowing to mortgage rates.
The Federal funds rate is the rate banks charge each other for overnight loans to meet the Fed's deposit requirement. The discount rate is a similar rate charged by the Fed to banks. One basis point equals one one-hundredth of a percentage point.
Over time, the higher interest rates should become a drag on the economy and on the stock market.
The rate hike was expected by many on Wall Street. About half the economists on Wall Street expected the increase, while half believed the Fed would hold off. A CBS.MarketWatch.com poll of a dozen economists produced a 43 percent chance of a rate hike.
The Federal Open Market Committee was persuaded to raise rates not so much by troubling economic data as by the calendar. With the next FOMC meeting coming on Dec. 21, just 10 dys before the great unknown of Y2K, and the following meeting not until Feb. 1, the central bank opted for a pre-emptive move now instead of panicking the Millennium-fearing crowd or waiting for more than two months.
"I was surprised by the hike in the discount rate," Kellner said. "Maybe that makes up for the fact that it can't do anything for the next four months."
The economy has grown by more than 4 percent a year for the past three years even as unemployment sagged to a 29-year low of 4.1 percent.
Despite the tight labor markets, inflation has remained subdued. The Fed fears, however, that the good times created by the productivity boom can't last forever. A few modest moves now can save us from more drastic measures later, the Fed reasoned.
By Rex Nutting
©1999 MarketWatch.com, L.L.C