Interest boost is first in 4 years

Fed raises short-term rate by quarter-point, to 1.25%

Move telegraphed to ease alarm

With economy recovering, focus turns to inflation

July 01, 2004|By Jamie Smith Hopkins | Jamie Smith Hopkins,SUN STAFF

The Federal Reserve raised a key short-term interest rate yesterday by a quarter of a percentage point, the first increase in four years and a sign that the sun is setting on historically cheap money.

At 1.25 percent, the rate is still low - the sort enjoyed by Americans when Dwight D. Eisenhower was president. But economists expect this is just the first of a series of increases.

"The winds are changing," said Greg McBride, a senior financial analyst with Bankrate.com in Florida. "This is the beginning of the end of the era of ultra-low interest rates."

Yesterday's widely anticipated move was a good-news, bad-news event. The change signals that the Fed thinks America's economic revival has some staying power and the bigger concern now is keeping inflation under control.

It also means slightly higher bills will be coming due for millions of people and some companies that borrowed like there was no tomorrow.

Households have racked up $240 billion in non-mortgage debt just since 2001, when the Fed began slashing rates. That's an average of about $2,200 apiece.

Some banks reacted immediately yesterday afternoon, raising their prime lending rates from 4 percent to 4.25 percent. The interest paid on credit cards, home equity loans and car loans is linked to that benchmark.

Investors, pleased that the Fed offered no surprises, pushed stocks up yesterday as well. The Dow Jones industrial average rose 22.05 points to close at 10,435.48. The Nasdaq composite index was up 12.86 points, to 2,047.79. And the Standard & Poor's 500 index inched up 4.64 points, to 1,140.84.

James Butkiewicz, a professor of economics at the University of Delaware, expects to see interest rates eventually settling at 3 percent to 4 percent as the Fed tries to move back to normal.

"There's a lot of increasing to occur," he said.

Last raise in May 2000

The Fed last raised its federal funds rate - what banks charge one another for overnight loans - in May 2000. It began cutting the next January as the economy slumped.

Three-and-a-half years of dropping rates is very unusual: The Fed has topped that only once since it broke free of the executive branch in the 1950s, and that was between 1989 and 1993, according to the Financial Markets Center in Virginia.

Investors panicked when the Fed raised rates afterward, in 1994, because they were startled by the rapidity of the increases. Economists think the Fed has been crystal clear in communicating its intentions this time, partly because it was stung by past experience and partly because this is an election year.

Signaled the markets

"If they hadn't done a quarter of a point, they might have been sued for inaccurate advertising," joked Susan M. Phillips, dean of the School of Business at George Washington University.

"They went out of their way - both the chairman and other members - to signal to the markets that this rate increase was coming. ... They'd rather not be an unnecessary influence."

A statement yesterday from the Fed's Open Market Committee noted that recent inflation data "are somewhat elevated," though it attributed some of that to temporary factors.

"With underlying inflation still expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured," it said.

"Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability."

Impact on debt

For the economists who parse every word to see what the Fed might do next, that suggested the possibility of more aggressive rate increases if inflation continues to grow.

"That's a bit of a shift," Phillips said. "I think it's appropriate."

It's not great news for debt-heavy consumers and businesses.

Companies that appeared to be doing fine in this period of unusually low rates might begin to fall apart as payments on variable-rate debt rise, said William H. Henrich, vice chairman of Getzler Henrich & Associates, a New York crisis management firm.

"Low interest rates can actually mask problems," he said. "To the extent that companies are walking more of a tightrope, they are going to be stressed."

Trickling down

Individuals will also have to adjust as the change filters through the economy, though this initial step will hardly break the bank. An increase of a quarter of a percentage point means $25 extra in interest a year for someone with $10,000 in credit-card debt.

If the Fed pushes rates to 3.75 percent by the end of next year as some economists expect, the extra interest rises to $275.

It really starts to add up for people looking to buy a home as mortgage rates rise, as they've been doing for several months in anticipation of Fed action. A 1 percentage point increase eats away about 10 percent of your buying power, real estate agents say.

There's a silver lining, of course.

"As interest rates go up on the loan side, so too will they be going up on the deposit side, so there is going to be a segment of the consumer population that will benefit," said Dick Oppitz, executive vice president and group manager for consumer leading at Provident Bank, based in Baltimore.

Earnings growth

Financial institutions usually dislike a rising-rate environment, but the ones with a lot of capital and low-cost deposits are cheering because low rates are a drag on earnings growth.

Mercantile Bankshares Corp., Maryland's largest independent bank, has watched its net interest margin drift downward since 2001.

Extreme circumstances

Edward J. Kelly III, head of Mercantile, was well and truly ready for the historical lows to start moving back to normal.

"That [portfolio] serves us well except in the most extreme circumstances, which we've experienced in the last three to four years," he said.

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