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Fed Hikes Interest Rates

The Federal Reserve pushed short-term interest rates higher by another quarter of a percentage point Tuesday, making good on Alan Greenspan's promise to move "promptly and forcefully" to combat inflation.

The announcement by the Federal Open Market Committee puts the Federal funds rate at 5.25 percent. The Fed funds, the rate that banks charge each other for overnight funds, is the major tool of the Fed's monetary policy.

The Fed also raised its discount rate, or rate it charges banks on overnight loans, by 25 basis points to 4.75 percent and adopted a "neutral" bias toward future increases, suggesting it won't need to raise interest rates again this year.

"Today's increase in the federal funds rate should markedley diminish the risk of rising inflation going forward," the Fed said in a statement.

The Fed cited "persistent strength in domestic demand," tight labor markets, and firmer foreign economies for the rate rise.

"The degree of monetary ease required to address the global financial market turmoil of last Fall is no longer consistent with sustained non-inflationary, economic expansion," the Fed said.

The Fed is trying to slow the economy just a bit to relieve inflationary pressures from tight labor markets. Higher interest rates should, over time, raise the costs of spending and investing for both consumers and businesses, forcing them to cut back and take the heat off the labor market.

Already, interest rates for home loans and corporate borrowing have jumped about a full percentage point from the lows achieved last fall and winter, largely in anticipation of the Fed's tighter policy. Concern about the Fed has also taken a little steam out of the stock market - one of the great sources of extra wealth that has fueled consumption and investment.

The Fed acted even though most gauges of inflation have remained remarkably tame. Both the Consumer Price Index and the Producer Price Index have showed little inflation outside of energy prices. However, wage pressures have been intensifying in recent months and productivity gains may be slowing.

In his Humphrey-Hawkins testimony a month ago, the Fed chairman pointed to the possibility that wages and benefit costs would creep higher under the pressure of tight labor markets just as the once-in-a-generation revolution in productivity tapered off. Higher employment costs would lead businesses to raise their own prices, if possible, to recoup those costs.

Financial markets were widely expecting the rate hike. Stocks and bonds have rallied in the past week or two after interpreting the friendly CPI and PPI data to mean that the Fed, although vigilant, won't need to raise rates again this year.

The Fed also raised rates at its June 30 meeting, citing imbalances that could foster inflation and the recovery of international capital markets from the crisis of last summer and fall.

By Rex Nutting, Washington bureau chief for CBS MarketWatch

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