The Federal Reserve yesterday raised interest rates to their highest levels in nine years and hinted that it may act again soon to cool the sizzling economy and keep inflation at bay.
The Fed funds rate after yesterday’s action stood at 6.5 percent. The Fed also increased its discount rate, the interest it charges for direct loans to banks, by a half point to 6 percent.
Major banks quickly increased their prime lending rate to 9.5 percent from 9 percent after the Fed raised two key bank lending rates by a half point ensuring that the rate increases will be passed along to businesses and consumers through mortgages, credit cards and home-equity loans.
“The Fed really has to control the consumer’s appetite for buying so aggressively. It’s truly been extraordinary,” said Lyle Gramley, a former Fed governor now with the Mortgage Bankers Association.
Mr. Gramley said the Fed will not stop raising rates until it sees convincing signs that consumers are simmering down. That probably will require two more quarter-point rate increases by August bringing the total to more than two percentage points, he said.
Spending hasn’t slowed in the past until the Fed raised the federal funds rate which is the rate banks pay on overnight loans to about the same level as economic growth, which recently has surged close to 7 percent, he said.
The central bank’s strongest action to date in a yearlong campaign to pre-empt inflation came after reports showed that economic growth and inflation were only accelerating despite the Fed’s five smaller rate increases since June.
The evidence of runaway growth was so strong, the Fed was undeterred by reports released just minutes before its rate-setting committee met yesterday showing a drop in home-building permits last month and no increase at all in consumer prices after two months of oil-induced price spikes.
The Fed is not alarmed so much about this spring’s uptick in inflation which remains “very, very modest” as it is about the acceleration of wage pressures that surfaced last month as the unemployment rate plunged to 3.9 percent, he said.
The drop in unemployment signals that the Fed may have to take more aggressive action than it previously planned to prevent a wage-price inflation spiral from developing and that is very difficult to do without tipping the economy into a recession, he said.
Richard Yamarone, economist with Argus Research Corp. in New York, warned of “grave economic consequences” if the Fed moves too aggressively because of “snowballing inflation fears.”
He noted that “real” interest rates subtracting the inflation rate are higher now than at any time since the 1990 recession, creating “extremely restrictive” financial conditions for businesses that hope to expand and as well as for consumers.
“Many economists claim that [such high rates] prompted the 1990-91 recession. It has long been said that expansions don’t die, they are killed by the Fed,” he said. “Such aggressive behavior could send the economy southward, perhaps as early as 2001.”
Business and labor groups also said the Fed has gone too far.
“The Fed is resorting to unnecessary shock treatment,” said National Association of Manufacturers President Jerry Jasinowski. “Concerns with a shrinking labor pool are exaggerated,” he said, noting that unemployment has been near 4 percent for several years without setting off inflation.
“There is absolutely no indication that higher wages are causing higher inflation,” said AFL-CIO President John J. Sweeney. “Far from being a problem, we should celebrate this achievement.”
Other analysts said the economy is so robust and consumer finances are so healthy that the Fed’s sharp rate increases will hardly make a dent in consumer spending, much less cause a recession.
“This will only modestly affect overall auto sales,” said Paul Taylor, chief economist of the National Automobile Dealers Association. The rates on bank and credit union loans will go up, he said, but auto companies will keep offering buyers very favorable below-market rates as low as 2 percent.
Sales of cars and sport utility vehicles have been hurt more by the recent turbulence in the stock market than by rate increases, he said, noting that stock losses are particularly hitting sales of high-end luxury vehicles.
In anticipation of the Fed’s actions, the average rate on 30-year mortgages rose last week to 8.52 percent, the highest in five years. Yet “demand is so strong today that rates could go to 10 percent or 10.5 percent without a hit to the housing market,” said Neil Bader, president of Skyscraper Mortgage.
Joel Naroff of Naroff Economic Advisers in Holland, Pa., noted that yesterday’s big short-term rate increase will make it harder for home buyers to evade higher rates from now on by resorting to adjustable-rate mortgages, which are no longer low in comparison to fixed mortgage rates.
“Housing demand may suffer,” he said. “Without big gains in the stock markets, the conditions are in place for an economic slowdown.”
While the Fed still has another “bullet in the chamber,” he said, “even a whiff of a softening in the economy” should allow it to sit back and wait for a few months before moving rates up again.