No end's in sight to Fed's rate cycle

Another quarter-point rise is likely today, experts say

Funds rate to be boosted to 3.5%

Growth, oil prices may require increases through next year

August 09, 2005|By KNIGHT RIDDER/TRIBUNE

WASHINGTON - The Federal Reserve is expected to increase short-term interest rates today for the 10th consecutive time, raising questions about when this 15-month cycle of quarter-point increases will draw to a close.

Many analysts say the Fed is all but certain to raise its benchmark federal funds rate, which banks charge each other for overnight loans, by the usual quarter of a percentage point to 3.5 percent. That drives up many consumer bank-loan rates, including the prime rate.

The Fed has been nudging up short-term rates since June 2004 to keep a lid on inflation, which erodes consumer purchasing power. As rates rise, they make borrowing more expensive, dampening economic activity.

Whether further rate increases will be necessary may depend on the price trend for crude oil and other fuels and how those prices are passed through to industry and consumers. The Fed's Open Market Committee aims to find a neutral zone for lending rates that promotes growth but doesn't overheat the economy and trigger inflation.

Fed Chairman Alan Greenspan told Congress last month that inflation is contained for now, but lurks as a threat.

Crude oil prices are setting new records almost daily - approaching $64 a barrel yesterday - although after adjusting for inflation, oil prices were higher in the early 1980s.

"A further rise [in energy prices] could cut materially into private spending and thus damp the rate of economic expansion," Greenspan told the Senate banking committee on July 20.

So far that hasn't happened. The U.S. economy grew at a 3.8 percent annual rate in the first quarter of this year and a 3.4 percent annual rate in the second quarter.

"The economy is doing quite nicely, so we expect the Fed to continue to tighten," said Augustine Faucher, a senior economist at Economy.com, a consulting firm in West Chester, Pa. He forecasts Fed rate increases through 2006, though at a slower pace, ending next year at 4.75 percent.

"The biggest wild card remains energy prices," he said. "If oil remains near $60 per barrel, that could lead to broader inflation, while at the same time weighing on economic growth. This would present the Fed with a major dilemma."

Those who think the Fed will continue raising rates point to Greenspan's favorite inflation gauge, called the Core Personal Consumption Expenditures Price Deflator. The index measures the average increase in prices for all domestic personal consumption, the largest component of the gross domestic product - the sum of a nation's goods and services. From June 2004 to June 2005, the measure rose by 1.9 percent.

When the index exceeds a 2 percent annual rate, it raises fears that inflation is breaking loose. However, the April-June quarter's numbers were less ominous, at 1.4 percent.

"The deflator has moderated in recent months, so should the rates keep going up or not?" asked John Silvia, chief economist for Wachovia, the banking giant in Charlotte, N.C. He expects more Fed rate increases in September and November, but said the outlook beyond that was anybody's guess.

James W. Paulsen, chief investment strategist for Wells Capital Management, part of Wells Fargo & Co., worries more about rising commodity prices for goods such as copper and aluminum than about oil. He thinks the question for the Fed is whether the world economy is heating up or slowing down.

"Economic growth has proved far stronger and broader globally than most expected, [corporate] profits have been much stronger and the consumer has been remarkably resilient. The Fed, based on these facts, will bias the discussion toward continued tightening," Paulsen said.

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