Fed Again Hikes Interest Rates : Economy: Major banks follow suit, leading to higher borrowing costs. Some economists say half-point jump, an inflation-fighting move, increases likelihood of recession.

WASHINGTON — The Federal Reserve Board on Wednesday raised interest rates for the seventh time in its yearlong battle to hold U.S. economic growth to a sustainable level and preempt inflation. During a closed-door meeting of its main policy-setting committee, the nation’s central bank acted to increase its two benchmark short-term rates by half a percentage point each, hiking its federal funds rate to 6% and its discount rate to 5.25%--double the level of a year ago.

The moves immediately prompted major commercial banks to increase their prime interest rates to 9%, which in turn is likely to lead to higher borrowing costs for millions of Americans who have credit cards, variable-rate mortgages and other adjustable loans tied to the prime rate.

Evidence that the national economy is still growing at a robust pace and that declining unemployment is leading to labor shortages in some regions of the country had convinced Federal Reserve Chairman Alan Greenspan and other Fed officials that Wednesday’s rate hike was needed.

Even recent “tentative signs” of slowing growth were not enough to convince the central bank that it should not raise rates, it said in a statement.

Wall Street reacted positively to the widely anticipated rate hikes, with the Dow average gaining 3.70 points to close at 3,847.56 on Wednesday. But financial markets have been roiled for months by uncertainty over the direction of prices and interest rates.

Some economists, however, warned that the interest hikes could increase the likelihood of a recession early in 1996.

Increasingly, some private economists are expressing concerns that the Fed has moved too far, too fast to quell inflation at the expense of economic growth. In fact, the more widespread use of variable-rate loans in the economy in recent years has accelerated the effect of the rate increases.

Many economists who don’t share Wall Street’s great fear of inflation said the economy now seems certain to suffer a sharp slowdown in the second half of 1995 and could move into a recessionary phase early next year.

“There’s a good chance of a recession next year,” cautioned Donald Ratajczak, an economist at Georgia State University. “When we get to 1996, we will be squeezing and squeezing down on growth, and we will still probably see higher inflation and interest rates, and that could tip us over from economic growth of about 1% to 1.5% and into negative territory.”

“We think the economy will slow down dramatically in the second half of 1995, and we’re starting to worry about a recession early in 1996,” said David Wyss, an economist at DRI-McGraw Hill, an economic forecasting firm in Lexington, Mass. “I think the chances are we will still avoid a recession, but I think the risks of one are increasing.”

As a result, a growing number of economists are critical of the central bank’s single-minded focus on inflation, especially because there is still little evidence of upward price pressure in the economy a year after the Fed began increasing interest rates.

The Fed appears to be setting its interest rate policy according to the theory that economic growth above 2.5% a year and an unemployment rate under 6% cannot be sustained without causing inflation. With the national jobless rate down to 5.4% in January and the economic growth rate at 4.5% for the fourth quarter of 1994, the bank has plenty of ammunition to prove its case for raising rates.

But increasingly, outside economists are using the term “overkill” to describe those policies.

“The problem is the Fed is trying to slay a dragon that they can’t see and that no one else can see either,” said Robert Hormats, vice chairman of Goldman Sachs International.

The central bank’s latest rate increases almost certainly are bad news for California, which has found itself in the awkward position of being out of sync with the rest of the nation.

While the state has begun to pull out of its economic problems, higher rates are likely to constrain its recovery, many economists believe. California could be in the same situation that bedeviled the industrial Rust Belt of the upper Midwest in the early 1980s, when rising interest rates severely hurt the auto and steel industries.

“California will find it hard to recover when the rest of the country is way ahead in the cycle and is already about to slow down,” Wyss said.

The timing of a recession early in the 1996 presidential campaign also would complicate political matters for President Clinton, who has seen the country’s strong economic performance as one of his greatest political assets.

In a White House statement Wednesday, Treasury Secretary Robert E. Rubin and Laura D’Andrea Tyson, who chairs the White House Council of Economic Advisers, insisted that the Administration “neither endorses nor criticizes” Federal Reserve policy.

The Administration said the rate increases will not force it to change its new economic forecast, which will be released next week as part of the fiscal 1996 budget.

But Democratic lawmakers on Capitol Hill voiced concerns Wednesday, and even some Republicans complained.

“This is sorry news for the American people,” said Sen. Tom Harkin (D-Iowa). “Once again, Chairman Greenspan has favored Wall Street over Main Street--favored the bond market over family budgets.”

The Fed argues, however, that ultimately there is no alternative to managing a “soft landing” for the economy. Greenspan has said inflation must be fought before it appears because once it arrives it is too late to stamp it out.

The central bank has only a mixed record, however, in managing soft landings. The severe 1990-91 recession came after the Fed began raising rates to avoid a slump. Economists noted that there have been 11 cycles of monetary contraction in the United States since World War II, and all but two have led to recessions.

Signs of slower growth in the auto and housing industries already are contradicting the broader measures of rapid economic growth. While many measures of activity are at peak levels now, “the numbers are beginning to appear to be more mixed and conflicting,” Hormats said.

And many fear that the Mexican economic crisis will curtail U.S. exports--which have been a critical source of strength since the last recession.

Still, most economists are not yet willing to predict a recession. Many still believe that the nation may scrape by with very slow growth in 1996--but growth nonetheless.

“Economies tend to fool people with their resiliency,” said Allen Sinai, chief economist at Lehman Brothers-Global Economics.

* CONSUMER IMPACT: What the rate hike means for savers and borrowers. D1.