Fed officials in bind on rates

No change could signal lack of faith in economy

Market reaction is feared

Central bank is caught by its words of optimism

August 10, 2004|By William Neikirk | William Neikirk,CHICAGO TRIBUNE

WASHINGTON - The Federal Reserve is in a bind, trapped by its optimistic words of the past and an economy suddenly not living up to expectations.

When Chairman Alan Greenspan's central bank meets today, analysts said, the Fed is likely to increase interest rates modestly even though economic conditions do not appear to merit it.

Increasing interest rates when the economy appears to have lost steam is a choice that no central bank likes to make, especially in an election year where slow job growth is a key issue.

But the Fed's credibility is at stake.

First, analysts said, bumping up rates this week would follow the central bank's "measured" game plan of gradually restoring rock-bottom rates to more typical levels. Second, they said, not raising rates would signal that Greenspan believes the economy is in worse shape than imagined.

Several economists said that if the central bank goes ahead with the expected rate increase of a quarter-percent today, there might not be another increase in September, as had been previously expected.

Beyond that, the Fed may be put in the unfortunate position of eating crow and momentarily abandoning its strategy of driving short-term interest rates higher by a couple of percentage points during the next year.

"I think they are going to pull back a little," said William T. Zadrozny, chief executive officer of Siemens Financial Services. "I think they will indicate that they will move when they have to move," rather than follow a gradual but steady step-up in interest rates.

The economic slowdown that began in the second quarter and continued into July has thrown the Greenspan Fed off stride.

The Open Market Committee signaled at its June meeting that it would increase interest rates in gradual increments during the next year and a half. At the time, the recovery looked solid enough. Small interest-rate increases did not appear to be harmful if carried at a gradual pace.

But a slowdown in sales and hiring began in June and extended into July. And last week, the Labor Department reported that employers slowed down their hiring last month to a crawl.

"It is a difficult choice," said Nigel Gault, economist at Global Insight Inc., a consulting firm. To increase rates would mean taking the kind of step that usually tends to slow the economy, he said. "If they don't, there's a risk it could backfire on them."

It could backfire in the place where the Fed least wants a negative reaction: the financial markets of the United States and the world. There could be a sell-off and more volatility in the stock market, said Gault.

Michael Drury, chief economist at Memphis-based McVean Trading and Investments, a futures trading firm, predicted that the dollar would slide and world financial markets would go into a tizzy if interest rates are not raised.

"They've already pretty much promised the markets that interest rates will go up one quarter of one percentage point," Drury said. "Can they break that promise now? They'll brutalize the financial markets if they do."

Gault said the Fed in recent times has gone to great pains to prepare financial markets for its next move, and any departure from that carefully calculated preparation would not be well-received.

At its last meeting, the Fed's policy-making arm, the Federal Open Market Committee, voted unanimously to increase its benchmark "federal funds rate," which financial institutions charge each other for borrowing, from 1 percent to 1.25 percent.

At the time, it noted that "output is continuing to expand at a solid pace and labor market conditions have improved," adding that it would raise rates at a pace "that is likely to be measured." Greenspan appeared before Congress in July and issued an optimistic economic outlook, calling for a strong growth in the second half of the year.

Then reality intervened. The "soft patch" that the Fed chief saw in June slipped into July. Last week, the Labor Department reported that employers added only 32,000 payroll jobs in July, signaling that the recovery had slowed.

Drury called it "the pause that refreshes," meaning that the economy is poised to bounce back again with strong job creation. Some analysts believe that the job figures announced last week may have understated employment growth.

The Chicago Tribune is a Tribune Publishing newspaper.

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