World and Nation

In surprise move, Fed raises key interest rate

WASHINGTON — Taking a step to normalize lending after holding interest rates to extraordinary lows for more than a year to prop up the financial system, the Federal Reserve on Thursday raised the interest rate it charges on short-term loans to banks.

While the central bank had telegraphed its intentions to take such a step, the timing was a surprise. The announcement was made after the stock market had closed in a carefully worded statement that emphasized that the Fed was not yet ready to begin a broad tightening of credit that would affect businesses and consumers as they struggle to recover from the economic crisis.

But while the move will not directly affect home mortgage, credit card or auto loan rates, it was a clear signal to the markets, politicians in Washington and the country as a whole that the era of extraordinarily cheap money necessitated by the crisis was drawing gradually to a close.

The Fed announced that it was increasing its discount rate on loans made directly to banks by a quarter of a percentage point, to 0.75 percent from 0.50 percent, effective Friday.

It also took a number of other steps to begin unwinding its efforts to keep the banking system functioning after the real estate bubble inflicted huge losses that were amplified by sophisticated bets made by Wall Street.

Given the slow and uneven nature of the recovery, an unemployment rate still close to 10 percent and fears of a new wave of mortgage defaults, particularly in commercial real estate, few economists expect the Fed to begin a campaign of broader interest rate increases. The central bank reaffirmed last month that the key short-term interest rate it controls would remain “exceptionally low” for an “extended period,” language it has used since March.

Having taken a baby step toward a return to normalcy, the Fed’s chairman, Ben S. Bernanke PhD ’79, now faces a delicate dance in the months ahead.

The central bank will try to drain from the financial system some of the money it created to keep banks and the economy afloat over the last two years. And at some point it will begin putting upward pressure on interest rates by raising its benchmark fed funds rate, the rate at which banks lend to each other overnight.

Uncertainty surrounds the timing and sequence of those steps. Bernanke is scheduled to present the Fed’s semiannual monetary policy report to the House on Wednesday and the Senate on Thursday — testimony the markets will watch closely.