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Fed Raises Rates After Seven Years Near Zero, Expects ‘Gradual’ Tightening Path

The Federal Reserve said it would end a seven-year experiment with near-zero interest rates by raising its benchmark rate and emphasizing a plan to lift it gradually over the next three years.

The move marks a test of the economy’s capacity to stand on its own with less central-bank support to spur continued spending and investment by households and businesses.

“The Fed’s decision today reflects our confidence in the U.S. economy,” Fed Chairwoman Janet Yellen said Wednesday in a press conference after a two-day policy meeting. “We believe we have seen substantial improvement in labor market conditions and while things may be uneven across regions of the country, and different industrial sectors, we see an economy that is on a path of sustainable improvement.”

Investors took the upbeat message to heart. The Dow Jones Industrial Average rose 224.18 points, or 1.28%, to 17749.09. The advance continued in Asia early Thursday, with stock markets in Japan, Hong Kong, Australia and South Korea moving higher.

The Fed’s move promises to ripple across the globe. The anticipation of higher rates and stronger growth in the U.S. has driven investors to push up the value of the U.S. dollar. That in turn has hit commodities prices and companies in emerging markets that borrowed heavily in dollars during the low-rate period. A stronger currency is making it harder to pay off those debts.

The Fed leader won a unanimous vote, the capstone on a tumultuous year marked by wavering and internal disagreement about when to move.

Fed officials are proceeding with great caution. They said they would raise the benchmark federal-funds rate—an overnight interbank lending rate—from near zero to between 0.25% and 0.5%, and would adjust their strategy as they see how the economy performs.

“We have very low rates and we have made a very small move,” Ms. Yellen said to underscore her own caution.

New projections show officials expect the fed-funds rate to creep up to 1.375% by the end of 2016, according to the median projection of 17 officials, to 2.375% by the end of 2017 and 3.25% in three years. That implies four quarter-percentage-point interest rate increases next year, four the next and three or four the following. It depends on whether the Fed’s forecasts for the economy—which have frequently been wrong in this expansion—hold up.

The pace of rate increases projected by officials is somewhat slower than what they saw in September and much slower compared with earlier cycles of Fed rate increases. In the 2004-06 period, for example, the Fed raised rates 17 times in succession, a staccato approach Fed officials don’t intend to repeat.

“The committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate,” the central bank said in its policy statement.

When the Fed moves next will depend on how inflation evolves. The Fed’s preferred measure of inflation has run below its 2% objective for 3½ years, pushed down of late by tumbling oil prices, which fell Wednesday to their lowest level since February 2009.

The central bank focused on the inflation outlook in its policy statement, and Ms. Yellen suggested it might alter its course if its projection of a gradual rise in inflation doesn’t materialize as expected. Fed officials don’t want inflation to run below their 2% goal for long periods because they see that as a sign that the broader economy isn’t living up to its potential.

“We do need to monitor inflation very carefully,” Ms. Yellen said. If it doesn’t pick up, “we would need to take further action to reconsider the outlook and to put in place appropriate policy.”

For now, officials said they were “reasonably confident” inflation would rise, because the domestic economy is improving.

Any number of factors might throw the Fed off its plans. Persistently low inflation, a shock to the financial system or slowing growth from abroad could force the Fed to delay further rate increases or even reverse course.

“The real economy is still suffering,” said William Spriggs, chief economist at the AFL-CIO and an economics professor at Howard University in Washington, D.C. He said the Fed made a mistake by raising rates and committing to raise them further, which he said will slow down the economy and hurt workers as households continue to recover from the recession and sluggish recovery.

On the other hand, an unexpected acceleration in economic growth or inflation, or a new financial boom, could lead officials to lift borrowing costs more quickly than they now expect.

“Frankly, that would be good news” because it would mean the economy was performing better than expected, said Anil Kashyap, an economics professor at the University of Chicago Booth School of Business.

For now, John Bergstrom, chief executive of Bergstrom Automotive, a Neenah, Wis., company with 30 dealerships in the state, said he didn’t expect a quarter-percentage-point rate increase to do much of anything to his business.

A rate increase of that size, he estimated, would increase the average cost of a car by $4 a month. That’s offset by the boost households have received from lower gasoline prices, he said, which he estimates saves them $200 a month.

During the financial crisis, he closed 12 dealerships, he said. Now sales are booming. They have reached $1 billion this year, compared with $850 million before the 2007-09 recession. “A little bit of an interest-rate hike is not going to be a big problem,” he said. “We are ready to get back to business as usual.”

While auto sales have boomed, manufacturers are struggling with the effects of a strong dollar and weak global economy, which is hurting their ability to sell goods overseas. Tumbling oil prices have also hit the energy sector.

Taken altogether, Fed officials see a domestic economy that has made enough progress to warrant a slow retreat from easy money. The jobless rate has fallen to 5% in November from 10% in 2009. Officials believe inflation will rise in 2016 as slack in the job market diminishes and oil prices stabilize.

Officials predicted the economy would expand at an annual pace between 2.4% in 2016 and 2% in 2018, which would take the expansion to a decade in length. They saw their preferred measure of inflation rising from 0.4% in 2015 to 1.6% in 2016 and then to 2% by 2018. The jobless rate is seen stabilizing at 4.7% during the next three years. These projections were largely in line with earlier estimates.

Whether other interest rates—such as on savings accounts, mortgages, car loans and corporate loans—rise as well depends on how investors, businesses and households respond.

U.S. lenders—including J.P. Morgan Chase & Co., Wells Fargo & Co., Bank of America Corp.—said Wednesday that they would raise their so-called prime rate, a key reference rate for a variety of loans including credit-card debt, to 3.5% from 3.25%.

The market doesn’t always follow the Fed’s lead. Between 2004 and 2006, when the Fed raised its benchmark short-term rate 4.25 percentage points, yields on 10-year U.S. Treasury notes and corporate bonds and mortgage rates barely budged because of strong global appetite for U.S. securities.

Michael Lussier, chief executive of Webster First Federal Credit Union in Worcester, Mass., said banks and credit unions now could be slow to adjust rates on certificates of deposits and other savings accounts, potentially bad news for retirees looking for higher returns on their fixed-income investments.

“You are not going to see an instant change in CDs on Thursday, that’s a guarantee,” he said in an interview ahead of the Fed’s release. A 12-month CD at First Federal yields 0.4%.

The central bank has been telegraphing the rate increase for months. By moving now, the Fed could put new pressure on emerging markets, particularly corporate borrowers in these countries that took out U.S. dollar loans which have gotten more expensive as the dollar rises in value.

The junk bond market is already reeling. Yields on low-rate junk bonds have jumped from 6.61% at the beginning of the year to 8.79%. A retreat from junk bond funds prompted Third Avenue Management LLC last week to suspend withdrawals, which added to investor anxiety about the sector.

“In waiting as long as it has to begin rate normalization; the central bank may have allowed this process to reach a point where domestic growth appears to have potentially crested as we head into the hiking cycle,” said Rick Rieder, a portfolio manager at BlackRock Inc.