- The Washington Times - Wednesday, June 30, 2004

The Federal Reserve yesterday raised interest rates for the first time in four years, bringing to an end an extraordinary interlude since September 11, 2001, in which Americans enjoyed the cheapest credit in a generation.

The quarter-point that the central bank added to the cost of home-equity loans, credit cards and other consumer bills was a gradual start to what Fed-watchers say will be a long and steep climb in interest rates in the next year or two.

Average mortgage rates already have jumped from 5.38 percent to 6.25 percent in anticipation of the Fed’s move. The rates on shorter-term loans such as credit cards and second mortgages will rise as banks mimic the Fed. Major banks started that process by raising the prime lending rate a quarter-point to 4.25 percent yesterday.

The end of the Fed’s extraordinary efforts to nurture the economy back to health with rates not seen since the 1950s and 1960s came after evidence this year that the recovery is on track and creating jobs, while inflation has unexpectedly roared back to life.

Promising further “measured” moves in coming months, the Fed yesterday noted the improved labor conditions as well as “elevated” inflation, which quadrupled to a 5 percent rate this year largely because of outsized food and energy price increases.

The Fed was optimistic in predicting that the price flare-up does not present serious concerns over the long run, noting that “a portion … appears to be transitory,” in an apparent reference to easing of oil, gasoline, food and other commodity prices in recent weeks.

“The inflation picture has improved considerably,” said Richard Yamarone, economist with Argus Research Corp., but “the Fed couldn’t keep its foot on the economy’s gas pedal forever.”

Oil prices have dropped 12 percent from record highs, and Mr. Yamarone noted that the feverish prices on other vital products from copper and steel to milk, corn and sugar also have fallen by double-digit amounts thanks to a slowdown of China’s torrid economic growth in recent months.

Although the reawakening of inflation forced the Fed’s hand, Chairman Alan Greenspan has emphasized that the Fed is not alarmed and that its goal is only to nip inflation pressures in the bud by removing stimulus that is no longer needed to keep the economy afloat.

The Fed will keep moving rates up in quarter-point increments, unless growth and inflation unexpectedly fall off or accelerate, economists say.

Rate increases of a half-point are possible after meetings of the Fed’s rate-setting committee every six weeks if core inflation, excluding food and energy prices, rises outside of a range between 1 percent and 2 percent that is acceptable to the Fed, they say.

Although the Fed is moving in an unhurried way, the reason economists say rates ultimately will end up sharply higher is because the level where rates would be “neutral” — that is, no longer stimulating or slowing the economy — is the Fed’s ultimate goal.

To achieve “neutrality,” Lynn Reaser, chief economist with Banc of America Capital Management, says the Fed will have to raise its main rate tool, the federal funds rate, to between 4 percent and 5 percent from its 1.25 percent level today.

The funds rate is the rate that the central bank targets on overnight loans to banks. The quarter-point increase that the Fed announced yesterday applies to the funds rate and the discount rate it charges on emergency loans to banks.

Ms. Reaser expects rates to climb back at “neutral” levels by the end of 2006. She expects rates to remain “moderate” as long as inflation and economic growth do not rage out of control.

Although most consumers have nothing to fear from moderately higher rates, the long period of steadily declining rates from double-digit levels in the early 1980s to 40-year lows in the past year most likely is over, Ms. Reaser said.

That is because core inflation bottomed out at a little more than 1 percent last year, she said. The Fed put a floor under inflation at that level by announcing it would work to prevent any further price declines that threatened to usher in a destructive deflationary spiral such as the one that gripped Japan in the past decade.

The Fed’s action also spells the end of an historic home-refinancing boom that enabled consumers to dramatically lower their debt payments in the past three years and take extra spending money out of the rising cash value of their homes.

Those who refinanced with low, fixed rates should be largely immune to the rate increases, analysts say. The consumers hit hardest by higher rates will be those with mounting credit-card debts and home-equity loans that are tied to floating rates like the prime.

“In the past, low interest rates gave many consumers a false sense of stability and tempted them to increase their credit-card usage,” said Chris Viale, chief executive of Cambridge Credit, a financial counseling firm.

“Consumers who spent above their means during previous interest-rate cuts are just now realizing the negative effects their decisions have had on their financial situation,” he said. “Americans with high levels of personal debt and especially those in lower income brackets will definitely feel a pinch.”

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