- The Washington Times - Wednesday, January 28, 2004

The Federal Reserve yesterday sparked a sell-off on Wall Street with a statement that noted the economy’s “brisk” growth and hinted at the possibility of higher interest rates.

Despite the central bank’s assurances that inflation remains low and new jobs remain so scarce that it can be “patient in removing” the stimulus of extraordinarily low rates, the Dow Jones Industrial Average plummeted 142 points to 10,468 on fears that a rate increase could be only months away.

Rates in the bond market surged as investors braced for action by the Fed, with the yield of Treasury’s 10-year bond jumping to 4.19 percent from 4.08 percent. That ensures the rates on 30-year mortgages and other long-term loans will be rising in the days ahead.

“The days of incredibly low interest rates are likely behind us,” said Joel Naroff, president of Naroff Economic Advisers. “The statement was almost glowing in its description of the economy, even to the extent that the weakness in the labor market was downplayed.”

The central bank pointed out that most labor-market indicators have improved, including first-time claims for jobless benefits and help-wanted advertising, although “new hiring remains subdued.”

Fed Chairman Alan Greenspan has gone out of his way in recent speeches to express his confidence that job growth is poised to make a comeback this year.

Mr. Naroff said the Fed is signaling that it will start raising rates once it sees “a rapid acceleration of job growth.” While that could happen by this summer, he said, the markets are wrong in assuming the Fed will act that quickly.

Any increase in interest rates by the Fed would have a dramatic impact not only on financial markets, but the housing market as well, which has seen an unprecedented boom as a result of a 40-year low in interest rates engineered by the Fed.

Sales of new and existing homes in 2003 hit a record for a second consecutive year, although new-home sales posted an unexpectedly steep 5.1 percent decline in December, the Commerce Department reported yesterday.

A rise in interest rates could also affect the pace of business investment, the recovery of which is still fragile, as seen in an unexpected leveling off of durable-goods orders at factories reported by the department for December.

“It is doubtful that the Fed will need to tap on the brakes anytime soon,” said Richard Yamarone, economist with Argus Research Corp, who does not expect a rate increase until next year. “Employment remains mired in a funk, with little to no indication of picking up.”

Mr. Yamarone and some other Fed watchers questioned whether the markets were overreacting to a semantic change by the Fed.

The central bank yesterday dropped a key phrase included in statements since August saying that it was likely to keep rates low for “a considerable period.”

Much speculation had centered on that phrase, with most Wall Street analysts concluding that it meant rates would stay low indefinitely. The removal of the phrase was the immediate cause of yesterday’s sell-off.

Mr. Yamarone said the Fed was not signaling a dramatic change in the interest-rate outlook, but rather was correcting the mistaken impression that its “obfuscatory” phrase had created.

“The Fed had to right a wrong,” he said, after sending “confusing signals to the financial markets.”

Lynn Reaser, chief economist with Banc of America Capital Management, said the change was subtle, but unmistakable.

“While a relatively small nuance, the language change removes the perception that interest rates could stay unchanged throughout 2004,” she said. Ms. Reaser expects the Fed to tighten rates around the middle of the year.

“By that time, enough evidence of strong economic growth, job gains and a firming in underlying price trends would make appropriate a gradual shift,” she said.

Lawrence Kudlow of Kudlow & Co. applauded the Fed for abandoning the “infamous phrase” and said the move toward tighter policy was needed to bolster the sagging dollar. The prospect of higher rates touched off a rally in the dollar yesterday.

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