The Federal Open Market Committee on Wednesday voted unanimously to raise the federal funds target, which commercial banks charge each other overnight, to 1.25% from a 1958 low of 1%.
It was the first in a series of small steps expected to gradually return the key rate to normalcy – about 4% at the current inflation rate - by the end of 2005.
"Strong growth in the US economy coupled with a rise in inflation has induced the Fed into tightening monetary policy," said Swiss Re chief economist Kurt Karl.
"This is the first in many rate hikes, which will likely take the federal funds rate to 2.25% at the end of this year and 4.0% by the end of 2005," he said.
With inflation relatively low except for some apparently transitory hotspots, Federal Reserve chairman Alan Greenspan and his colleagues confirmed that they expected to move at a "measured" pace.
"Strong growth in the US economy coupled with a rise in inflation has induced the Fed into tightening monetary policy"
Swiss Re chief economist
Investors cheered the news, sending the Dow Jones industrials average up to 22.05 points, or 0.21%, to 10,435.48.
But the policymakers also vowed to do whatever is needed if inflation rears unexpectedly.
The latest evidence showed the world's biggest economy was growing at a "solid pace" and job market had improved, FOMC members said in a statement.
Risks to growth and inflation appeared balanced, they said.
"Nonetheless, the committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability."
Greenspan and his colleagues sprung into action only after a jobs drought broke and prices began to rise.
Since January 2001, they had cut rates steeply to offset the popping of the technology bubble in the late 1990s, the September 11 terrorist attacks, corporate scandals and the wars in Afghanistan and Iraq.
White House spokesman Scott McClellan said the rate rise "is a reflection that the economy is growing stronger."
Democratic presidential contender John Kerry's campaign avoided direct comment but said Bush's policies had put upward pressure on longer-term borrowing costs.
"The real issue is that George Bush's abandonment of fiscal discipline will mean higher long-term interest rates," Kerry's economic advisor Gene Sperling said.