Fed rate rises despite oil fears

America's central bank last night shrugged off the impact of rising oil prices on a slowing economy when it raised interest rates for the second time in six weeks to keep inflation in check.

The Federal Reserve announced it was raising its federal funds rate from 1.25% to 1.5% following a similar move at the end of June. It blamed dearer energy prices for signs of weaker growth but sought to reassure a jittery Wall Street that further increases would come at a "measured" pace.

The unanimous decision by the Fed's open market committee came on the day that New York oil futures briefly broke through $45 a barrel before falling back on news that Iraq was restarting production from its southern fields after Monday's sabotage threats.

Crude prices edged slightly lower on both sides of the Atlantic, but dealers remained convinced that the market would test the $50 a barrel level in the near future.

"The prospect of a cessation of Iraqi exports from the country's southern ports for a prolonged period would almost certainly be enough to push oil prices above $50 a barrel since there is not enough spare capacity to cover the 1.7m-1.9m bpd [barrels per day] of oil exported from Basra," analysts at Barclays Capital said.

US light crude touched $45.04 a barrel, a record in the 21-year history of crude futures trade on the New York Mercantile Exchange, before the news of restored Iraqi supplies sent prices down 32 cents on the day to $44.52. London Brent crude was down 28 cents at $41.28.

"The world has one of the smallest cushions ever for absorbing a loss of supply while demand growth is the stron gest in a generation," said Daniel Yergin, chairman of US consultancy Cambridge Energy Research Associates. "These conditions mean the world oil market is even tighter than in the 1973 oil crisis."

In a statement explaining its decision, the Fed said that even after raising interest rates from their 40-year-low of 1%, monetary policy was still loose enough to be helping the US economy to grow.

In recent months, output growth had moderated and job creation slowed, probably owing to the rise in energy prices. "The economy nevertheless appears poised to resume a stronger pace of expansion. Inflation has been somewhat elevated this year, though a portion of the rise in prices seems to reflect transitory factors."

The FOMC put the upside and downside risks to growth and inflation over the next few quarters on an equal footing, and made it clear that a rapid increase in interest rates was not in prospect. With underlying inflation still expected to be relatively low, the committee believes policy accommodation can be removed at a measured pace.

The Fed's optimism over future growth appeared to cheer investors. Although shares initally dipped on the news they then continued their upward march during the day and the Dow Jones closed up 130 points at 9944.

However, analysts were wary of reading too much into the rise. "The Fed did what it was expected to do. But in the long term, in light of the economic weakness, this bounce we're seeing in stocks is really not meaningful," said Hans Olsen at Bingham Legg Advisers in Boston.

"I think we need to look at the subsequent economic data and then to third-quarter earnings to see what kind of economy we're going to have."