Saying that the economy was still getting stronger, the Federal Reserve raised its benchmark short-term interest rate again yesterday and gave investors reason to think that it would continue lifting rates through the end of the year.
The Fed lifted the rate to 3.5 percent, from 3.25 percent, the 10th increase since last summer, as the economy has recovered from recession and its long hangover.
The change in the benchmark - which directly affects many credit card and business loans and usually influences mortgage rates though with a lag - had been expected. But the Fed's rate-setting committee also tweaked the language in its public statement after the meeting to note that economic growth had picked up.
"Aggregate spending, despite high energy prices, appears to have strengthened since late winter," the statement said, "and labor market conditions continue to improve gradually."
The Fed now seems to be in a race against the economy's gathering strength, with policy makers hoping that they did not keep interest rates low for a long enough time to ignite inflation. Many Wall Street economists are growing worried about that possibility, while others - especially on the left - say that job and wage growth remain too weak for serious inflation fears.
After President Bush met with his economic team yesterday at his ranch in Crawford, Tex., he sidestepped a question about whether higher interest rates could slow the economy, saying that energy and health care were his top concerns.
The chairman of the Council of Economic Advisers, Ben Bernanke, speaking with reporters, said: "Inflation is well contained, under control. The core inflation rate over the last year is about 2 percent, and I see inflation remaining well contained going forward."
The Fed reiterated that it planned to raise short-term rates at a "measured" pace, a term that is widely thought to mean that it would continue to move in quarter-point increments.
Investors expect the benchmark rate, the federal funds rate, to reach 4.25 percent by the end of the year, based on the price of a futures contract that tracks Fed actions. That would require the Fed to lift the rate at each of its three remaining meetings in 2005.
In the spring, when economic growth looked weaker than it has recently, investors were betting that the key rate would end the year at 3.75 percent.
"A policy mistake may have been made," said Laurence H. Meyer, a former Fed governor and now vice chairman of Macroeconomic Advisers, a forecasting firm. "They may have lingered too long" at interest rates that will eventually cause a surge in inflation.
The housing boom, a recovery in business investment and strong consumer spending have kept the economy growing at a steady pace despite oil prices that have reached the highest levels since the early 1980's, adjusted for inflation.
On Tuesday morning, stocks rose slightly, after a Labor Department report showed that productivity growth had slowed less than expected in the second quarter, and the market held onto its gains after the Fed's announcement in the afternoon. The Standard & Poor's 500-stock index closed at 1,231.38, up a little more than 8 points.
In a sign that investors might have expected the Fed to express more concern about inflation than it did, the interest rate on the 10-year Treasury note slipped to 4.39 percent, from 4.42 percent late Monday.
In its statement, the Fed used many of the same words that it did last month to describe its attitude toward prices.
"Core inflation has been relatively low in recent months and longer-term inflation expectations remain well contained," it said, "but pressures on inflation have stayed elevated."
The fact that long-term interest rates, including those on mortgages, remain lower than they were a year ago, when the Fed started raising rates, has perplexed many analysts, and the causes are not clear. This has made the Fed's job more difficult, preventing the rate increases from slowing the economy as they typically do.
In recent weeks, long-term rates - which are set by day-to-day trading in the bond market - have risen somewhat, which probably took some pressure off Fed officials to issue a stronger statement about inflation risks.
The benchmark interest rate now exceeds inflation, which has been running about 2.5 percent a year, by a small amount. In the language of the Fed, that means the rate is still below the "neutral" level and is still pushing the economy ahead instead of holding it back.
The Fed chairman, Alan Greenspan, has declined to say publicly just what the neutral level is. "We don't know what neutrality is until we get there," he told Congress last year.
Many forecasters say it is in the neighborhood of 4 percent, which is why they expect the Fed to continue raising its benchmark for the rest of the year. In previous cycles, though, the Fed struggled to avoid overreaching, and raising or cutting rates more than looked necessary in hindsight. At times later, it had to reverse course.
"The spooky part is that Greenspan and others have said they don't know what neutral is," said Robert J. Barbera, chief economist at ITG, "but they'll know it when they see it. A fairer thing to say is probably that they don't know what neutral is, but they'll know it when they've passed it."
The labor market is also complicating the Fed's attempt to understand the economy's direction. Wages for most workers have recently been rising no faster than inflation, often a sign that the economic growth is not healthy enough to set off inflation. New technologies and the movement of some jobs to low-wage nations seem to be holding back wage and price increases.
But another possibility is that pay increases will come with time. Raises often lag behind job growth by months or even years, and some economists say that the Fed should continue increasing interest rates to prevent wages, and inflation, from spiraling over the next year.
"Politically, they're not going to come out and say, 'We don't want to see unemployment come down any more,' " Maury N. Harris, chief United States economist at UBS, said, referring to Fed officials. "But I think what they would like to see is an economy that grows just fast enough to keep unemployment stable."
In its report yesterday, the Labor Department said that unit labor costs, a measure of pay for each unit of output, rose 4.3 percent over the last year, the fastest growth since 2000. But most of the increase occurred late in 2004. In the second quarter of 2005, unit labor costs rose at an annual pace of just 1.3 percent.
Using the same words it did at its last meeting, the Fed called productivity growth "robust."
Mr. Bush praised the economy over all, saying that job growth was strong and that trade agreements were opening new markets. But his advisers struggled to explain why, if the economy was improving, public confidence remained shaky, as numerous polls show it does.
Allan B. Hubbard, director of the National Economic Council, said that most people "in terms of their personal finances, feel very good about the economy."
"At the same time, there is unease about the economy in general," Mr. Hubbard said. "None of us are comfortable paying $2.50 per gallon when we go to fill up our cars with gas." And, he said, "We are a nation at war."
Both Mr. Hubbard and Mr. Bernanke said that health care costs were a major topic of discussion at the ranch meeting, but declined to specify what if any policies the president intended to pursue to address them.
