- The Washington Times - Wednesday, March 29, 2006

The Federal Reserve yesterday raised short-term interest rates to the highest level in five years, giving no hint that it is nearing an end to its nearly two-year-long campaign to head off inflation.

In the first meeting of its rate-setting committee led by new Chairman Ben S. Bernanke, the Fed by unanimous vote dismissed the sharp slowdown in the economy in the fall as “temporary” and cited high energy and commodity prices, as well as constraints on the labor force that limit the economy’s ability to grow, as reasons for continued vigilance.

The Fed has raised rates by nearly four percentage points in 15 actions since June 2004, leaving the rates on credit cards, home equity loans and adjustable-rate mortgages in most cases equal to or higher than the rates on long-term loans such as 30-year mortgages, which last week averaged 6.3 percent. The prime lending rate, after yesterday’s latest quarter-point increase, rose to 7.75 percent.

Although Fed watchers cheered the central bank’s determination not to give ground to inflation, Wall Street and Main Street analysts increasingly fear the central bank is in danger of overdoing it and pushing the economy into a slump.

The Dow Jones Industrial Average fell 96 points after the Fed’s announcement, while rates on Treasuries and other bonds shot up on signs of further rate increases ahead.

“The Fed is in danger of overshooting” because it “is more worried about inflation than economic growth,” said economist Roger Kubarych of HVB Group. With core inflation — excluding food and energy — running about 2 percent, the inflation-adjusted level of interest rates is at levels that brought on recessions in the past, he said.

“Interest-rate-sensitive sectors, notably autos and housing, are already showing strains,” he said, noting that both General Motors Corp. and Ford Motor Co. are in financial straits with sinking credit ratings and declining sales that many analysts fear will force the automakers into bankruptcy.

Although manufacturers are struggling, consumer confidence and spending have rebounded this year after hitting a 12-year low in the fall, buoyed by improving job prospects. The Conference Board reported yesterday that its measure of consumer confidence hit a four-year high this month.

“A miscalculation in interest rate policy could damage the economy and force the Fed to reverse course later in the year by giving back one or two rate hikes,” said Bernard Baumohl, executive director of the Economic Outlook Group.

This is most likely to happen if Mr. Bernanke, a specialist on monetary policy whose background is primarily academic, is not as attuned as his predecessor Alan Greenspan was to subtle signs that the economy is moving toward a substantial slowdown later this year, he said.

One such sign is the steep decline in the housing market since the fall. The housing boom had been a major driver of economic growth in recent years, with fast-appreciating house prices providing an important source of strength to consumers, who have cashed out at least $750 billion from their home equity to spend on other things since 2001, he said. Consumer spending generates about 70 percent of economic activity.

Other signs that growth is sure to wane are consumers’ high debt burdens and growing delinquencies among the many borrowers who took out adjustable-rate mortgages in recent years and are now facing sharply higher mortgage payments as a result of the Fed’s actions, he said.

“Servicing all that debt was manageable when interest rates were low,” Mr. Baumohl said. “But the Fed has been jacking up rates nonstop for 21 months, and the debt-service burden is starting to pinch.”

Mr. Baumohl said the Fed would be overdoing it if it goes beyond raising the federal funds rate, its principal tool for influencing short-term rates, another quarter-point to 5 percent at the next meeting of its rate-setting committee in May. But he thinks it is more likely that the Fed will be convinced by then that the economy is slowing enough that further rate increases are not warranted.

Mark Vitner, senior economist at Wachovia Securities, agreed that the Fed is likely to pause after raising rates one more time in May, despite the likelihood that economic reports before then will show the economy rebounded to a robust rate of growth in excess of 5 percent during the first quarter from 1.6 percent at the end of last year.

“The Fed will not be unnerved by swings in the quarterly [growth] figures,” Mr. Vitner said, though its goal is to cool growth to a little less than 3 percent.

Richard Yamarone, economist with Argus Research Corp., said he expects the Fed to raise rates three or more times.

“History tells us that the Fed has always overshot its tightening goal,” he said. “Central bankers like to know the cork is firmly implanted in the bottle so that the inflation genie doesn’t sneak out. The worst thing a central bank can do when fighting inflation is fall behind the curve.”


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