Fed faces a dilemma over decision whether to raise interest rates

Increase could compound Katrina-related problems, but inflation poses risk

September 16, 2005|By KNIGHT RIDDER/TRIBUNE

WASHINGTON -After the Sept. 11, 2001, terrorist attacks on New York and Washington, the Federal Reserve Board responded by slashing interest rates in a morale boost that spurred consumption. Since then, borrowing for both mortgages and consumer loans has soared to record highs amid a nationwide housing boom.

Now the Fed's dilemma is this: Katrina might have slowed consumer spending, and another rate increase could compound that. But Katrina's spike in oil and gasoline prices also poses an inflationary risk that is usually countered through increases in the lending rate.

In addition, there's another wrinkle: If the Fed doesn't take a breather next week, it could be seen as insensitive at best, cruel at worst.

`Wrong message'

"Politically, I wouldn't raise rates on the 20th," said David Wyss, chief economist for Standard & Poor's in New York. "Raising rates when you are trying to recover from a disaster like this is sending the wrong message."

Working in favor of a pause, the Labor Department's consumer-price index for August, released yesterday, showed prices rising just .05 percent for consumer goods, below forecasts.

Core inflation - excluding volatile food and energy price - remained at .01 percent, where it has been since May. This suggests that higher energy prices are not stoking inflation, reducing the pressure on the Fed to raise interest rates in response.

Since June 2004, Greenspan has been raising the federal funds rate - the overnight rate banks charge each other - at what he calls a "measured pace." The quarter-point increases are intended to contain inflation without squashing economic growth. The Fed's rate increases generally point the way for bank rates on consumer loans and adjustable-rate mortgages.

Had Hurricane Katrina not struck the Gulf Coast on Aug. 29, an 11th consecutive rise in interest rates would have been a foregone conclusion, even though pre-Katrina data for August wholesale prices showed that rising energy costs were not spilling over to inflate the broader economy.

Fed feelings on rates

The Fed is trying to make sure inflation does not ignite by acting ahead of its resurgence, and has made clear that it doesn't think rates are high enough to ensure that.

Still, Katrina and her subsequent energy shock introduced a measure of doubt about the strength of the U.S. economy, and left uncertain whether an 11th-consecutive rate increase is coming.

"If my decision were based solely on economic considerations, I would tighten again. I think the economy won't be derailed by this," said Mark Zandi, chief economist for Economy.com, a forecasting group in West Chester, Pa. "I think the economy is firm, and they [the Fed governors] can send a signal that things are as they were."

`Considerations'

But, Zandi acknowledged, "there are political considerations and they may overwhelm the economic ones."

A pause by the Fed makes sense now, said Peter Morici, a University of Maryland, College Park business professor who is a Fed watcher.

"Taken together, prospects for a reversal of recent energy price increases and the absence of other fundamental inflationary pressures indicates inflation provides no significant justification for raising interest rates further at this time," Morici said.

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