US rate rise aims to stop boom becoming bust

Fears of higher interest rates around the world were raised last night when the US Federal Reserve board aimed a pre-emptive strike at inflation by increasing the cost of borrowing in America.

The US central bank raised rates by a quarter-point to 5.25% - the second increase in two months - in an attempt to prevent America's longest post-war boom spiralling out of control.

Other central banks such as the Bank of England and the European Central Bank are likely to come under pressure to follow the Fed's lead as global markets and the world economy continue to recover from last year's turmoil.

US share prices initially staged a strong rally - taking the Dow Jones Industrial Average to new heights - but then fell sharply as traders appeared to take profits. The price on the benchmark 30-year US treasury bond also rose.

The Fed indicated that it had no plans to raise rates further this year in yesterday's statement explaining the unanimous decision. However, the Fed made the same remarks after raising rates by 25 basis points in June and some analysts refused to rule a further increase later in the year.

In its statement yesterday, the Fed said: "Today's increase, together with the policy action in June and the firming of conditions more generally in US financial markets over recent months, should markedly diminish the risk of rising inflation going forward."

After last year's crisis, the Fed cut US rates by 0.75 points, a move which kept the economy thriving and helped the Dow to reach a record high on Monday.

Yesterday, the Fed warned that there was a threat of the expansion in the economy generating higher inflation. With financial markets functioning more smoothly, the domestic economy strong and foreign markets on the mend, interest rates no longer needed to be so low.

Richard Berner, chief US economist at Morgan Stanley Dean Witter, the US investment bank, said: "This is not a tightening of monetary policy because inflation is a clear and present danger, but because it's a future danger."

The debate inside the Fed is being mirrored inside the Bank of England, where one faction on the nine-strong monetary policy committee is pressing for higher base rates as insurance against inflation. A decision could come this autumn.

The US economy, in its ninth year of expansion, had 2.1% inflation in the 12 months through July. That rate is on track this year to be the third lowest in more than a decade.

The Fed has grown increasingly concerned, however, about rises in wage inflation and the US trade deficit. The employment cost index rose 1.1% in the second quarter, nearly triple the first quarter rate.

Yesterday's news had been widely expected. A Bloomberg News survey recently found 29 of the 30 primary dealers expected a quarter-point rate increase for overnight lending between banks - and most say that will be it for the year.

Related story
25 August: Mr Fed keeps steady hand on the tiller