In a widely expected move, the Federal Reserve (search) Wednesday raised its target for the federal funds rate by 25 basis points to 1.25 percent, its first rate increase in four years.

In its post-meeting statement, the central bank repeated a pledge to follow a "measured" pace, which markets have taken to imply it will opt for a course of smaller, quarter-point rate increases rather than larger ones.

The decision by Fed Chairman Alan Greenspan (search) and the rate-setting Federal Open Market Committee (search) still keeps the federal funds rate (search) for overnight loans between banks at historically low levels. 

The fed funds rate, the interest that banks charge each other on overnight loans, is the Fed's primary tool for influencing the economy. The Fed cut rates 13 times since early 2001 in an effort to foster a vigorous expansion.

With the economy gaining momentum, enough to generate 1.2 million jobs so far this year, the Fed is expected to move rates up gradually in several steps this year and into 2005.

As a result of the Fed's decision to push up the funds rate, commercial banks' were expected to increase by a corresponding amount their prime lending rate for many short-term consumer and business loans. The prime rate, which has been at 4 percent, the lowest level in more than four decades for a year, is expected to rise to 4.25 percent.

Fed policy-makers, wrapping up a two-day meeting Wednesday, held to the view that they could gradually raise rates to head off inflation. The Fed said it believes any rate increases can be "at a pace that is likely to be measured."

The Fed made clear, however, if will take more aggressive action if needed. This restated a position that Greenspan had articulated earlier.

"The committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability," the Fed policy-makers said.

Their latest assessment of the state of the economy was upbeat. The Fed said the economy is expanding at a solid pace and that labor markets are improving. On the inflation front, the Fed said that "although incoming inflation data are somewhat elevated, a portion of the increase in recent months appears to have been due to transitory factors."

Reuters and the Associated Press contributed to this report.