The reviews are in, and the Federal Reserve's latest move to push up short-term interest rates is a smash hit.
The Siskels and Eberts of the financial world are giving the Fed a solid thumbs-up for raising two key rates - the discount rate and the federal funds rate - by 0.5 percentage points each. It was the fifth time the Fed has raised interest rates this year.
Tuesday's move pushed the federal funds rate, which banks charge each other for overnight loans, to 4.75% from 4.25%. The discount rate, which the Fed charges on its own loans to banks, rose to 4% from 3.5%.
That double-barreled shot helped stifle Fed watchers who had feared the central bank and its chairman, Alan Greenspan, were going soft on inflation. "Greenspan and company have proven themselves to be the dedicated inflation fighters they always claimed to be," says Robert Heady, editor of Bank Rate Monitor newsletter.
Some of the Fed's toughest critics apparently agree. Bond prices soared after reports of the Fed's decision hit the news wires. Bond yields, which move in the opposite direction of prices, plunged. "The Fed has relieved a lot of the anxiety that has been brewing the financial markets the past few weeks," says Wall Street economist Maria Ramirez.
Some analysts say the hope of stable rates - more than heightened investor confidence in the Fed's toughness - is what sparked Tuesday's powerful bond-market rally. While bond investors fear inflation, they also dislike higher short-term rates, which makes bonds look less attractive. "It may be that we won't have to worry about any more of this Singapore-style caning for the rest of the year," says Sung Won Sohn, chief economist for Norwest.
Consumers have less to applaud. The Fed's move will mean higher rates on auto loans, home equity loans and consumer lines of credit. Rates on many of those loans are pegged to the prime rate, which banks charge to their largest and most creditworthy customers. The USA's big banks wasted no time following the Fed's lead. Within minutes, Chase Manhattan announced it was raising its prime rate to 7.75%, from 7.25%. Other large banks quickly followed, pushing the prime to its highest since it stood at 8% in November 1991.
Depositors and savers, on the other hand, can give at least a small cheer. The Fed's rate hikes should help boost the meager yields available on money market mutual funds, bank certificates of deposits and other short-term accounts. But don't expect a miracle. When it comes to adjusting deposit rates, banks are lagging the Fed.
Prior to Tuesday's move, the Fed had raised the federal funds rate a total of 1.25 percentage points since it began boosting rates February 4. During that same time, money fund yields rose 1.17 percentage points. The yield on a 6-month bank CD rose just 0.73 percentage points. Reason: Most banks are sitting on mountains of cash, thanks to huge profits they made investing in bonds in 1991-93. "The banks are flush," says Heady. "They don't need to bid for deposits."
That trend isn't likely to change. "It'll be a hot day in Siberia before banks get deposit rates back to where they should be," Heady says.
For home buyers, the Fed's latest move likely will prove a mixed blessing. Long-term mortgage rates are linked to bond yields. So if Tuesday's bond market rally lasts, rates on 30-year fixed mortgages, which now average 8.57%, should fall. But most adjustable-rate mortgages are pegged to shorter-term Treasury securities. Rates on those securities have risen in step with the Fed, pushing the average rate on a 1-year ARM to 5.56%, from 4.12% in early February.
In part, higher lending rates are what the Fed wants. Fed policymakers hope higher rates will slow the pace of economic growth enough to head off inflationary pressures, without pushing the economy into a recession. The economy grew at a 3.7% annual rate in 1994's second quarter. While the economy appears to have slowed in recent weeks, it's still growing faster than the 2% to 2.5% annual rate most economists believe is consistent with low inflation.
Will the Fed's latest move do the trick? Fed policymakers seem to think so. Following its recent practice, the Fed announced the latest rate increases in a press release. In doing so, they also hinted that further rate hikes aren't imminent.
But unless the economy slows sharply and soon, most economists think the Fed eventually will have to raise rates again, although probably by a more modest 0.25 percentage points. Most expect the Fed to wait until after the November congressional elections. Already, the Fed is drawing criticism from nervous politicians. "The Fed made the wrong decision and went too far today," says Rep. Martin Sabo, D-Minn., chairman of the House Budget Committee, who notes the consumer price index is rising at less than a 3% annual rate. "Inflation clearly is stable," he argues.
Indeed, the pickup in inflation has been relatively modest so far. But surging prices of some commodities suggest inflation will heat up at least slightly in coming months. "Wage pressures aren't much to get upset about yet," says David Blitzer, chief economist at Standard & Poor's. "But I look at the price of so-called boring commodities - steel, copper, lumber, iron. They're all going way up." Other signs of a strong economy:
-- Housing. New home construction this year could outpace 1993's healthy pace - despite rising mortgage rates. Tuesday, the Commerce Department reported housing starts rose 4.7% in July, rebounding from June's 9.4% drop.
-- Jobs. More than 2 million jobs have been created so far this year. And more jobs are coming. "Businesses have fairly good profits and they're running up against capacity constraints," says David Jones, chief economist at Aubrey Lanston & Co., a Wall Street brokerage firm. "Those are classic, old-fashioned job-creating conditions."
-- Consumer spending. While consumer spending did slow last quarter, part of that was due to shortage of new autos. Many economists expect spending to revive when new-model cars hit dealer showrooms later this year.
Consumer borrowing should continue to support spending. Consumer installment credit rose 13% from June 1993 to June 1994 - the fastest rate of growth since 1986. One big reason: Lenders are keeping consumer rates relatively low, even as the Fed raises rates. The average rate on an auto loan, for example, has risen to 8.53% from 7.91% - just 0.62 percentage points - since Feb. 4. That's less than half the increase in the federal funds rate. "Competition among lenders is still extremely intense," says Bob Stickler, spokesman for Florida's Barnett Banks.
One risk: Stronger growth in Europe and Japan could cause prices of raw materials and of imported goods to rise strongly in 1995, at the same time that U.S. exports are booming. That could push the U.S. inflation rate higher, even if economic growth slows. "That would put the Fed in a very difficult position," says David Hale, chief economist for the Kemper Financial Companies.
But Tuesday's rate increases, on top of the Fed's earlier hikes, leave Fed policymakers in a better position to check any emerging inflationary spiral next year. At the same time, those rate hikes shouldn't tip the economy too far the other way, causing growth to slow to a crawl.
"We're near the point where higher rates really start to bite into growth," says Mark Zandi, chief economist for Regional Financial Associates. "But we're not there yet."
Fed Raises Rates Economists applaud hike "These actions are expected to be sufficient, at least for a time, to meet the objective of sustained, non-inflationary growth." - Federal Reserve statement Tuesday, announcing increases in two key short-term interest rates.
"It's just another signal that the Fed is committed to keeping inflation under control." - Alan Bond, Bond Procope Capital Management
"The Fed is trying hard to re-establish its credibility . . . to get ahead of the curve." - Maria Rami
