Fed Action on Rates Hinges on Dollar’s Course

The U.S. Federal Reserve, mindful of recent turmoil in the financial markets, will likely maintain its grip on credit but may be forced to raise the key discount rate if the dollar’s tumble resumes, private economists say.

The Federal Open Market Committee, the Fed’s policy-making arm, will meet Tuesday to discuss the U.S. economy and to determine whether higher interest rates are needed to slow the dollar’s slide in currency markets and to calm mounting fears of raging inflation.

“I think the Fed will vote to keep policy where it is, but will give itself some flexibility to raise rates should the dollar plummet or inflation rise,” said Fidelity Bank senior economist Mickey Levy.

Financial markets have been reeling over concern about global economic growth, the massive U.S. trade deficit, the falling dollar and rising inflation.

“The subject of what to do about the turmoil in the financial markets will dominate the (FOMC) meeting,” said Lyle Gramley, senior economist for the Mortgage Bankers Assn. and a former Fed governor.

Gramley said the committee likely will not decide in favor of pulling in the credit reins any further, but it probably will not back off the tightening of credit that already has occurred in recent week.

However, the key is the behavior of the dollar on currency markets, Gramley and other economists say.

A steep drop could force the Fed to raise the key discount rate, currently 5.5%, that it charges banks for loans.

“If the dollar were to plunge, they would not have any alternative,” Gramley said.

In recent testimony before Congress, Federal Reserve Board Chairman Paul Volcker acknowledged that the central bank had tightened the money supply in an effort to halt the fall of the dollar. The move helped push up interest rates throughout the U.S. economy and at the same time the Bank of Japan was taking steps to lower Japanese short-term rates.

The efforts by the two central banks helped widened the gap between interest rates in Japan and the United States and thus helped bolster the dollar by making the U.S. unit more attractive to investors.

While the maneuver helped stabilize the dollar it remained under pressure amid persistently high trade deficits and signs of growing inflation.

Some economists are worried that a discount rate increase at this time will choke off growth and abruptly send the U.S. and, possibly, the global economy into a tailspin.

Frank McCormick, vice president and senior economist at the Bank of America, said the financial markets’ nervousness about rising inflation is unjustified.

“They are very much asking for someone, Paul Volcker, to hold their hand,” said McCormick.

McCormick said he believes the Fed will continue to tighten the Fed funds rate, the interest rate banks charge each other for overnight loans, but will not raise the key discount rate.

Some economists feel the Fed would be justified in raising the discount rate.

“I would like them to (raise the rate),” said Fidelity Bank’s Levy. “It’s the only rate that hasn’t increased yet, and I don’t think it would hurt financial markets that much,” he added.

Donald Ratajczak, director of economic forecasting at Georgia State University, said such a move is needed to stop the dollar’s slide.

“If we let the dollar continue to slide, it may be inappropriate not to raise interest rates,” he said.