Move by Japan Jars the Fed’s Balancing Act

The Bank of Japan’s move Thursday to hike interest rates adds another factor to an already complex equation that the Federal Reserve is trying to balance.

Should U.S. interest rates be notched lower to stimulate an economy teetering on recession?

Or should they remain unchanged to keep yields on American securities competitive with those elsewhere in the world?

Figure in the Persian Gulf crisis, and it is adding up to the most perplexing problem that the nation’s central bank has faced in nearly a decade.

“It makes things tactically a little more difficult for the U.S.,” said Robert Brusca, chief economist at Nikko Securities Co. International.

The increase in Japan’s discount rate boosted the cost of loans to financial institutions by 0.75% to 6%. The move was designed to cool a steamy Japanese economy and blunt the impact of oil prices driven higher by the turmoil in the Middle East.

The rate hike gave a lift to the sputtering Japanese stock market and also helped support the yen.

But market reaction was mostly negative in the United States, where both stock and bond prices declined. Higher Japanese interest rates could lessen demand for U.S. investments, particularly from the Japanese themselves, who have helped foot the bill for the U.S. budget deficit by buying Treasury issues.

Indeed, the flow of Japanese capital to U.S. coffers already has slowed sharply from year-ago levels, said Raymond Stone of Stone & McCarthy Associates in Princeton, N.J.

Attractive European interest rates also have lured investors away from the United States.

Still, investors may be attracted to U.S. securities for reasons other than yield. As interest rates decline, bond prices rise, increasing the opportunity for capital gains. So rather than invest in a bond because it is yielding 8%, investors might buy bonds on the assumption that rates will decline and the bond will appreciate in price.

The Fed is unlikely to take any action until the financial markets settle down from their monthlong bout of Persian Gulf jitters.

“With oil prices moving up sharply and inflation entrenched, the Fed is going to have to sit on the sidelines and watch some very unpleasant things happen until it can move,” Brusca said.

A rash move in one direction or the other could spell trouble. Raising rates could push the sluggish economy into recession. Easing could fuel the inflationary fires already stoked by the recent jump in oil prices.

Despite an inclination to maintain rates at higher levels to continue to lure critical foreign capital, experts say the Fed will set policy based on economic conditions at home.

Those conditions clearly call for lower interest rates, economists say.

“We’ve had an unbelieveable drop in consumer confidence . . . weak growth in employment, weak factory orders and with declining corporate profitability, how does the Fed do anything other than lower interest rates?” Brusca asked rhetorically.

But merely lowering interest rates is no guarantee that the economy would be kicked into a higher gear. According to Stone, long-term bond yields could actually move upward even if the Fed acts to ease short-term rates, such as those on overnight loans among major banks.

Long-term rates are set in the bond market and are based on a variety of factors such as currency fluctuations. A declining dollar, for instance, generally reduces demand for U.S. bonds, pressuring prices lower and yields higher.

“The Fed’s in a terrible position,” said Sonia Stromeyer, an economist with MMS International. “The financial markets are forward-looking, and an easier (interest rate) policy does not bode well for the inflation outlook.”