Fed Hikes Interest Rates Again; Blow to Recovery Feared : Economy: Inflation fears fuel year’s fifth increase. Move buoys markets but is likely to hamper growth nationwide and in sluggish California particularly.


In a controversial move expected to slow the nation’s economic recovery, the Federal Reserve on Tuesday raised short-term interest rates by one-half percentage point, the fifth time this year that the central bank has increased rates in its bid to curb the threat of inflation.

The Fed’s action to hike its two benchmark interest rates to their highest levels since the end of 1991 boosted stock and bond markets but brought warnings from an array of economists that the agency’s aggressive anti-inflationary policies are starting to weaken the recovery.

The Fed’s move poses particular risk to California’s still-sluggish recovery, where economic growth and job creation lag far behind the national average and thus are more sensitive to higher interest rates. California’s important housing industry is especially vulnerable should higher rates depress home sales.

Consumers could also be hurt as rates on other loans continue to rise while rates that banks pay for certificates of deposit and other savings aren’t expected to keep pace.


But the Fed signaled Tuesday that it is far more concerned about the potential threat to the economy from rising prices than from slower growth or higher unemployment.

Fearful of repeating its past mistake of waiting too long before attempting to stamp out inflation, the central bank voted to hike the federal funds rate, which banks charge each other for overnight loans, to 4.75%, while also increasing its discount rate, which the Fed charges commercial banks for short-term loans, to 4%.

Major banks, led by Chase Manhattan, quickly followed the Fed rate hikes and raised their prime lending rates to 7.75% from 7.25%.

The financial markets, which had widely anticipated that the Fed would raise rates Tuesday, welcomed the size of the rate hike. Many on Wall Street had expected a smaller move, but were pleased because the more aggressive action suggests that the Fed will not have to hike rates again soon, reducing the sense of uncertainty in the markets over monetary policy.


The Dow Jones industrial average gained 24.28 points Tuesday to close at 3,784.57, while the yield on the benchmark 30-year Treasury bond plummeted to 7.37% from 7.51% on Monday.

The drop in long-term bond yields led some lenders to cut their rates on 30-year, fixed-rate mortgages by a quarter percentage point on Tuesday. However, rates on other consumer borrowings, such as home equity and credit card loans, are expected to rise as they are tied to banks’ prime rates.

On the heels of Tuesday’s move by the Fed, many economists said they believe that the economy’s growth rate will plunge in 1995, and predicted that the economy will perform at a relatively sluggish pace for the remainder of President Clinton’s four-year term.

“What this means is that 1994 is as good as it is going to get for Bill Clinton in terms of economic growth,” observed Ross DeVol, an economic forecaster at the WEFA Group.


In its formal statement announcing the rate hikes, the Fed argued that it was not moving to quash growth, but was taking a preemptive step against inflation to allow the economy to continue to grow at a reasonable rate.

“These measures were taken against the background of continuing strength in the economic expansion,” the central bank said. “The actions are intended to keep inflationary pressures contained, and thereby foster sustainable growth.”

The Fed added that it does not believe it will need to raise rates again in the near future. “These actions are expected to be sufficient at least for a time, to meet the objective of sustained, non-inflationary growth,” the Fed statement said.

But the Fed could change direction again quickly, as it has in the past. It issued a statement after its last rate hike in May that also suggested officials at the central bank did not see the need for further action any time soon.


Above all, analysts said Tuesday, the Fed is signaling that it has adopted an aggressive policy designed to make “price stability” a higher priority than faster job growth.

Economists believe that the Fed’s moves show that it wants to keep inflation from growing by more than 2.5% to 3% per year--down from its current rate of about 3.5%--while also suggesting that the Fed believes the unemployment rate cannot fall below its current range of about 6% without leading to an inflationary spiral.

“I think this is a radical departure from past Fed policies, in that they are being far more aggressive in reaching their objective of price stability while largely ignoring the impact on employment and growth,” said Allen Sinai, an economist with Lehman Brothers/Boston Co. Economic Advisers.

In fact, economists said, they believe the Fed is concerned that economic growth has been too rapid over the past year. In the second half of 1993, the economy grew at a pace of about 5%. In the first half of this year, it grew by about 3.5%.


“We’ve added 329,000 jobs a month, on average, for the past five months, and the Fed seems to believe that kind of growth will increase inflationary pressures,” noted economist DeVol of WEFA Group.

“The Fed is now run by a group of people who are very heavily committed to the concept of price stability,” said Allen Meltzer, an economist at Carnegie Mellon University in Pittsburgh, Pa. “The message is that the Fed was not willing to tolerate the threat of 3% inflation in 1995,” added Sinai.

The Clinton Administration again sought to avoid a fight over interest rate policies, but issued a statement that seemed less enthusiastic in its support for the Fed than the White House had released following previous rate hikes.

“The Administration recognizes and respects the independence of the Federal Reserve to make decisions about the nation’s monetary policies,” said a joint statement from Treasury Secretary Lloyd Bentsen and Laura D’Andrea Tyson, chairwoman of the Council of Economic Advisers.


But other Democrats, fearing that the Fed’s actions could undermine the recovery, were more than willing to attack.

“What the Fed had done is place the narrow interests of the bond market far ahead of the American people who work hard for a decent standard of living,” complained Sen. Tom Harkin (D-Iowa), in a statement on the Senate floor Tuesday.

“Is the Fed acting in the national interest or chasing its long-held dreams of zero inflation to the detriment of American taxpayers?” wondered House Banking Committee Chairman Henry B. Gonzalez (D-Tex.), the Fed’s leading congressional critic. “Once again, (Fed Chairman Alan) Greenspan and the Federal Reserve have mugged America.”

Even major business groups joined in. “The Federal Reserve’s monetary tightening may be a case of too much, too soon,” argued Paul Huard, senior vice president of the National Assn. of Manufacturers. “The danger in raising interest rates (again) so soon is that the economy is probably poised for a slowdown anyway,” he added.


* FINANCIAL FALLOUT: Impact on consumers. D1

* MARKET REACTION: Stocks, bonds rally. D3