Fed raises key rate

Federal funds interest for overnight loans climbs a quarter point

Banks also boost prime

Stocks celebrate sign increases done for now

July 01, 1999|By William Patalon III | William Patalon III,SUN STAFF

The U.S. central bank's key policy committee nudged interest rates up a quarter-point to 5 percent yesterday, hinting it wouldn't raise rates further unless inflation surfaced as a real problem within the U.S. economy.

Consumers are likely to pay higher loan rates for cars, home-equity credit lines and such big-ticket luxury goods as boats. However, mortgage rates could fall.

The belief that the Federal Reserve Board is done raising rates for now -- a belief some economists dispute -- sent stocks and bonds galloping after the midafternoon announcement.

After two days of closed-door discussions, Fed policy-makers raised the federal funds rate, the maximum interest that banks charge each other on overnight loans, and indicated they were moving the policy directive, which signals the future course of interest rates, back to neutral.

"It's actually very significant," said Lynn Reaser, chief economist for Bank of America Private Bank in Jacksonville, Fla. The central bank's "stance returns to neutral, which indicates the Federal Reserve doesn't have a whole series of rate increases planned."

Indeed, yesterday's stock market gains indicate that investors believe the Fed's statement sweeps away the storm cloud of uncertainty that's been hovering since May 18, when a surging economy and tight labor markets prompted the Fed's announcement of a "bias" toward raising rates.

The Dow Jones industrial average, down roughly 50 points before yesterday's interest rate announcement, surged immediately after the Fed's disclosure and closed up 155.45 points, at 10,970.80. The Nasdaq composite jumped 44.30 points to close at 2,686.41.

Just as important, bond prices also rose, meaning the yield on the 30-year Treasury bond fell to 5.98 percent -- below the 6 percent level that investment strategists say signals danger for today's largely overvalued stock market.

Mortgage rates tend to move in the same direction as that yield, so it's possible rates for those loans could fall.

Bank of America Corp., the biggest U.S. bank; No. 2 Chase Manhattan Corp.; Bank One Corp.; and KeyCorp raised their prime rates to 8 percent from 7.75 percent yesterday, not long after the Fed made its announcement.

Since most other loan rates -- home equity loans, for instance -- follow the prime rate, it's likely consumers will find them becoming more expensive.

Higher interest rates slow the U.S. economic engine, two-thirds of which is fueled by consumer spending.

Higher rates also put a damper on the prices of stocks -- a point that's particularly poignant now thanks to a multiyear bull market that has left many consumers feeling relatively comfortable, and therefore willing to spend.

Almost as bad as higher rates is the fear that rates may go higher.

Yesterday's rate increase was anticipated. But the fear was that the Fed would, over time, take back the three-quarter-point rate cuts it made late last year when foreign economies collapsed and a U.S. hedge fund (a pseudo mutual fund for sophisticated investors) melted down.

During the past few weeks, a number of economists have said they expected the Fed to announce quarter-point rate rises after three of its meetings before year-end.

Other economists worried that there would be a half-point increase in the federal funds rate -- the most sensitive indicator of the direction of interest rates -- announced at the end of the Federal Reserve Open Market Committee's June meeting, held Tuesday and yesterday.

But yesterday, in announcing the quarter-point increase, the FOMC said contradictory signals from the economy caused it "to adopt a directive that includes no predilection about near-term action."

"The committee, nonetheless, recognizes that in the current dynamic environment, it must be especially alert to the emergence, or potential emergence, of inflationary forces that could undermine economic growth," it said.

Many investors and economists expressed relief in believing there would be no additional interest-rate increases this year.

Hugh Johnson, chief investment officer for Albany, N.Y.-based First Albany Corp., isn't so sure that's what the Fed is saying.

"I would not necessarily extrapolate that news quite as positively," he said. "I would not be surprised if the Federal Reserve sent a signal to make it clear it would not raise short-term rates in July and maybe August.

"[But to say] it cannot -- and will not -- raise interest rates further if it sees signs of inflation" is overly simplistic.

If the Fed sees any signs of inflation, "it won't hesitate" to act, Johnson said.

The Fed's decision to adopt a neutral stance by dropping its "tightening bias," as it did yesterday, is a move it has made every time it raised interest rates the past 11 years.

"A devoted student of monetary policy would know that the removal of a tightening bias when the Fed tightens is inconclusive as far as future monetary policy goes," said David Resler, managing director at Nomura Securities International.

"But by disclosing the removal of the bias, the Fed made it sound as if they will not move again. Transparency may have made monetary policy more difficult to interpret."

What Resler means is that, by disclosing its shifted stance, the Fed may have given economists and investors the wrong idea. Many experts say Federal Reserve Board Chairman Alan Greenspan is masterful at "jawboning" the financial markets into moving in whatever direction he feels is needed, meaning it's unlikely he made a misstep yesterday.

Until the past year or so, Greenspan had said the economy could grow at a 2.5 percent pace without forcing inflation. He's subsequently allowed that target to drift into the 3 percent range.

But the economy grew at a 6 percent annual pace in last year's final quarter and at a 4.3 percent annualized clip in this year's first quarter.

Wire services contributed to this article.

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