Fed Reportedly Prepares Series of Rate Increases

Senior Federal Reserve officials confirm that the central bank is poised to raise interest rates repeatedly in the months ahead, with some policy-makers embracing a controversial formula that could prompt them to call for rate hikes whenever national unemployment falls below 6.5%.

Now that the recovery is picking up speed and the economy is generating hundreds of thousands of new jobs each month, officials of the central bank say they are convinced that short-term interest rates must go considerably higher to prevent inflationary pressures from building.

If the Federal Reserve waits until consumer and producer prices begin to accelerate, they say, it will be too late for Fed policy to have much of an impact. Last week’s report of strong employment growth in April and a decline in the jobless rate to 6.4%--just below the 6.5% target used by some Fed officials--only served to reinforce the view within the central bank that it is time to apply the brakes before the economy begins to overheat.

While Wall Street analysts and economists have speculated about the likelihood of further rate hikes by the Federal Reserve, the virtual certainty of a continuing series of future increases was confirmed for the first time in interviews with senior Fed officials.

The exact timing and scope of future rate hikes is uncertain but several officials say that another upward adjustment could come as soon as the next scheduled meeting of the central bank’s policy-setting panel, the Federal Open Market Committee, on May 17.

Moreover, a few Fed officials say they are being guided in their decisions by statistical benchmarks suggesting that the unemployment rate already has fallen too far and that the economy is expanding too rapidly to keep inflation in check.

Although other Fed insiders, including Chairman Alan Greenspan, dismiss those formulas as too simplistic, their use suggests that at least some Fed officials might be willing to raise interest rates considerably higher than the Clinton Administration believes is warranted.

One Fed official said that such informal targets lead those who adhere to them to the conclusion that, given current conditions, the Fed should raise the benchmark federal funds rate to at least 4.5%, and perhaps as high as 5%. The rate currently stands at 3.75%. If the anti-inflation hawks are able to dominate policy-making, the central bank could impose as many as five more quarter-point rate hikes within the next year.

The Fed already has raised interest rates three times this year, boosting the federal funds rate by 0.25 of a percentage point each time. Aftershocks from the rate hikes continue to reverberate throughout the economy: stock and bond prices have declined sharply and borrowing costs have risen on everything from credit cards to home mortgages.

Treasury Secretary Lloyd Bentsen has said publicly that he expects the federal funds rate to rise to 4%, suggesting that the White House is willing to accept one more quarter-point increase. But some Fed insiders predict that even higher rates appear likely.

“My own feeling is that we have a ways more to go and we shouldn’t wait too long to do it,” says one senior Fed source, speaking on condition of anonymity.

“We are not there yet; we have more to do,” says a member of the Fed’s board of governors. “How many more, I don’t know.”

The economic targets being used by some Fed officials have become a source of debate within the Fed. Their adherents say that they involve two basic calculations: one target suggests that the Fed should strongly consider raising rates when unemployment falls below 6.5%. The other calls for consideration of rate hikes if the pace of economic growth exceeds 2.5%.

Based on the latest statistical readings, both thresholds already have been crossed. The government reported that the economy expanded at an annual rate of 2.6% in the first quarter of 1994 and April’s unemployment rate fell below 6.5%.

Rapid economic growth and job creation are generally believed to increase inflationary pressures by creating spot shortages of goods, services and labor, which enable producers and workers to demand higher prices. But there is widespread disagreement over the actual rates of employment and economic growth at which inflationary bottlenecks begin to appear.

While some Fed officials believe that their targets reflect the “natural rate” of non-inflationary growth and employment, insiders say there is little agreement within the Fed or among private economists over the accuracy and usefulness of such specific targets. So far, they are endorsed only by a minority of the members of the Open Market Committee and do not represent official guidelines for Fed policy-making.

Even so, the increasingly aggressive monetary policy has convinced critics that the Fed is willing to sacrifice a certain amount of job creation and economic expansion to keep future price increases moderate. Ultimately, that puts the Republican-dominated central bank on a potential collision course with a Democratic President who captured the White House largely on the strength of his pledge to create jobs and revive the economy. In fact, Bill Clinton staked his presidency last year on a deficit-reduction plan designed to stimulate growth by keeping interest rates low.

The Fed’s rate hikes could spoil that game plan right before crucial off-year congressional elections, in a year when Democrats appear especially vulnerable. While the White House has held its fire so far, congressional Democrats already are mounting a fierce attack, challenging the need for rate hikes and threatening to clip the Fed’s wings with legislation that would increase White House oversight of the central bank.

Just last week, Democrats on Congress’ Joint Economic Committee used their annual report to criticize the Republican-controlled Fed, a switch from previous years when they railed at GOP presidents. “Perhaps the greatest threat to sustained recovery would be continuing and unwarranted increases in interest rates,” the committee’s report said.

Fed officials say that some members of the Open Market Committee have embraced the new targets because their traditional yardstick--the growth rate of the nation’s money supply--is no longer reliable. Other Fed officials privately criticize their colleagues who adhere to fixed targets. Greenspan, for example, doesn’t base his policy decisions on them, arguing that they are overly simplistic.

“Sure, there are those who use those targets but I think people who base their policy decisions on that are kidding themselves,” one senior Fed official says. “Economists aren’t smart enough to know what full employment is.”

Few independent economists accept the analysis used by those who adhere to the targets. The traditional view in the economics profession is that full employment is reflected by a much lower unemployment rate, one closer to 4%. And, even under the revised unemployment data the government began using this year, data which tends to produce higher jobless rates than did the earlier surveys, Administration officials argue that full employment comes at a rate of unemployment between 5.5% and 6.0%.

“The Fed target of 6.5% is at the extreme high end of the range that economists have been using,” notes Daniel Bachman, an economist at the WEFA Group, a forecasting firm in Bala Cynwyd, Pa. “I think it is too conservative.”

So far, the Administration has studiously avoided joining in attacks on the Fed. But some Fed officials wonder how long the White House will be willing to maintain warm relations with Greenspan if the central bank continues to ratchet rates ever higher.

The Administration might find it easier to openly criticize the central bank once Clinton’s two pending nominees for the Federal Reserve board of governors are installed. The President has nominated White House economist Alan Blinder to be Fed vice chairman--making him the odds-on-favorite to succeed Greenspan in 1996--and UC Berkeley economist Janet Yellen to fill a second vacancy on the seven-member board.

* DOW SKIDS: A second consecutive surge in bond yields helped push the Dow down 40.46 points. D1