Fed seen pressured to up rates

May 09, 1994|By New York Times News Service

WASHINGTON -- For the fourth time in four months, the Federal Reserve is preparing to raise short-term interest rates. But its orderly plan to contain inflation might be disrupted by turbulence in the bond and currency markets, which is putting great pressure on the central bank to act more quickly and raise rates more sharply this time, economists said this weekend.

Alan Greenspan, the Federal Reserve's chairman, has signaled for a year in appearances before Congress an intention to raise interest rates before inflation begins to creep up again. But a spectacular rise in long-term interest rates on Friday, coupled with the sagging value of the dollar in international trading, have shown a broad lack of confidence by investors in the Federal Reserve's ability to control inflation, economists said.

As a result, they see the issue before the central bank as no longer whether to increase the short-term rates that banks pay to borrow money, but how early and how high.

Raising these short-term rates would dampen the potentially inflationary growth this spring of bank loans, and of the overall economy, because banks tend to make fewer loans and charge higher interest rates when they have to pay more to borrow money themselves. Without low-interest rate loans, many companies could no longer afford to build factories nor could many individuals afford to buy cars, slowing economic growth and inflation.

That could reassure bond investors, who worry that inflation will make their fixed, semiannual interest payments worth less over the years. Yet higher short-term rates is also likely to mean that consumers pay more interest on adjustable-rate mortgages, car loans and credit cards.

And while the Clinton administration has reluctantly come to nTC accept the need for some further increase in rates, Democratic members of the Joint Economic Committee of Congress warned on Tuesday that higher rates might not just restrain economic growth but stop it.

Higher rates for short-term loans, like the overnight borrowing by banks that the Federal Reserve most closely controls, tend to produce temporary increases in long-term interest rates for mortgages and 30-year Treasury bonds. But in the longer run, which may mean months or years, higher short-term rates tend to hold down long-term rates by preventing banks from making so many loans that they fuel inflation. And inflation makes people reluctant to invest in bonds for long periods of time.

The most common view among economists and former governors of the Federal Reserve who were interviewed this weekend was that the central bank would wait until the regularly scheduled meeting of its interest-rate policy committee on May 17 to raise rates again, partly because new figures on inflation in producer and consumer prices will be available by then.

"It they were going to raise rates on the basis of Friday's news, they would have done so on Friday," Lyle E. Gramley, a former governor of the Federal Reserve, said yesterday.

Mr. Gramley and other economists said the next increase in short-term rates was likely to be half a percentage point, compared with just a quarter-percentage point in each of the previous three moves. They also note that a further slump in the value of the dollar against other currencies could force the Federal Reserve to act sooner.

Some traders have suggested that investors could panic if the Federal Reserve does not move immediately to raise rates, but Wall Street economists tend to downplay this worry.

"If the Fed doesn't raise rates, there might be a few apoplectic analysts but the market will only erode a little bit," Robert Giordano, an analyst at Goldman, Sachs & Co., said.

Steep rises in long-term interest rates clearly worry top Federal Reserve officials. J. Alfred Broaddus Jr., the president of the Federal Reserve Bank of Richmond and one of the 10 current members of the policy-setting Federal Open Market Committee, said in an interview on April 29 that the level and stability of long-term interest rates were good measures of the central bank's effectiveness and credibility.

Mr. Broaddus and other members of the open market committee have declined to comment in the last few days on financial markets.

The yield on 30-year Treasury bonds soared on Friday to 7.54 percent from 7.33 percent, the biggest one day increase since just after Iraq invaded Kuwait in August 1991. Rates rose after the Labor Department announced that the American economy created 267,000 more jobs in April, a sign of economic strength that economists had not anticipated.

If the Open Market Committee raises short-term interest rates, this might prop up the sagging dollar by encouraging foreign investors to buy dollars so as to invest in American bonds. If the committee waits and the dollar drops through key psychological barriers, like trading at less than 100 Japanese yen for the first time since World War II, then subsequent interest rate increases might not succeed in pushing the dollar back up again.

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