OK, It Finally Happened--Now What?

The Federal Reserve Board did as expected Tuesday, tightening credit in the economy by raising a key short-term interest rate--the federal funds rate--from 5.25% to 5.5%. Here are answers to questions you may have about the Fed’s move and its effect on borrowing, investing and the economy in general.

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Q Why exactly did the Fed decide to raise rates?

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A We may know that when Chairman Alan Greenspan someday writes his memoirs.

On the surface, despite the strong U.S. economy, there are very few signs of the inflationary pressures the Fed is supposed to fight. The Fed says it is being “preemptive” in trying to slow the economy--in other words, firing before it sees the whites of higher inflation’s eyes. But economist Philip Braverman at DKB Securities in New York says that “this isn’t preemptive--it’s premature.”

Plus, everyone suspects that Greenspan has another agenda besides inflation: cooling what he has suggested might be excessive speculation in the stock market.

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Q What is the federal funds rate, anyway?

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A It is the rate banks charge each other for overnight loans. The Fed doesn’t set this rate directly, but rather influences it by transactions it carries out with the banks--either buying Treasury securities from the banks (infusing them with new money) or selling Treasury securities to them (draining money from them).

In any case, when the Fed sets a new “target” rate for federal funds, that’s usually where that rate stays. And as banks pay more, or less, for money in the federal funds market, they tend to raise or lower other interest rates as well, causing a ripple effect throughout the economy.

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Q Will this be the first of many rate increases?

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A Probably not even Greenspan knows for sure. But historically the Fed has rarely raised rates just once--there usually is a series of increases because the Fed tends to be “gradualist” in trying to affect the economy.

The conventional wisdom is that the Fed may raise the federal funds rate another half a point at most, returning it to the 6% level of the winter of 1995--a level that succeeded in slowing the economy.

But Bruce Steinberg, economist at Merrill Lynch & Co. in New York, believes the Fed might not have to touch rates again any time soon. “The economy would have slowed without Fed action. Now that is even more likely,” he said.

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Q What’s the best way to gauge the chances of more rate hikes?

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A Watch the economic data in April and May. That will tell the tale. If consumer spending, business spending, home sales and other key components of economic strength fail to weaken, the Fed will feel much more pressure to raise rates again.

Likewise, market interest rates--particularly on Treasury issues--will signal what investors believe the Fed will do. In recent weeks, for example, the yield on one-year Treasury bills has risen from 5.42% to 5.88%--a clear sign that the market believed the Fed would be boosting its benchmark rates.

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Q What will Tuesday’s Fed rate increase mean for borrowers?

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A Banks were quick to answer that question: Many of them raised their prime lending rates Tuesday from 8.25% to 8.5%. That will raise many businesses’ cost of borrowing almost immediately.

Some consumer loan rates, particularly on home equity credit lines, are tied to the prime, so borrowing that way will also get slightly more expensive soon.

Robert Heady, editor of the Bank Rate Monitor newsletter in North Palm Beach, Fla., expects the Fed’s quarter-point rate hike to translate into increases of 0.10 to 0.15 point in many consumer loans over the next six to eight weeks.

That may not be a big enough increase to dissuade many borrowers, but at the margin it may have some effect. That’s what the Fed wants--not to shock the economy, but to gradually bring down the rate of growth by slowing borrowing and spending.

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Q What about mortgage rates?

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A They have already risen, following bond yields in recent weeks and thus anticipating the Fed’s move. Long-term, fixed-rate loans cost about 8% now, up a quarter-point or more since early in the year, says David Lereah, economist at the Mortgage Bankers Assn. in Washington.

Many homeowners with adjustable-rate loans, meanwhile, will see their payments rise if short-term interest rates remain at current levels or rise further, although the speed with which that happens depends on the index a loan is tied to.

Overall, the MBA figures that for every quarter-point rise in mortgage rates, about 50,000 households get priced out of the housing market because they don’t qualify for the size of loan they need.

But Lereah concedes that the housing market has been quite strong this year and still has “a great deal of momentum.” However, if the bond market begins to assume the Fed will have to raise rates again, mortgage rates will rise in tandem, and that will become a more serious problem.

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Q What will savers get out of this rate increase?

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A Unfortunately, banks can be woefully slow in raising CD yields. Although Treasury bill yields have risen in recent weeks, the national average yield on six-month CDs has just inched up to 4.75% currently from 4.74% a month ago, according to the RateGram newsletter.

Still, Heady expects CD yields to rise a bit faster now that banks’ prime lending rate is going up.

Your best bet for cashing in on higher yields: money market mutual funds.

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Q What will a stingier Fed mean for the stock market?

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A Wall Street almost never likes it when interest rates are going up, for obvious reasons: Higher rates mean bonds and short-term accounts are greater competition for stocks. Plus higher rates raise companies’ cost of doing business, crimping profits.

Many analysts believe the market is in for rough sledding over the next few months, but they note that, longer-term, if the Fed succeeds in prolonging economic growth by slowing it, that’s ultimately good for stocks.

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The Fed Makes Its Move

The Federal Reserve Board on Tuesday raised one of its key short-term interest rates--the federal funds rate--from 5.25% to 5.50%, the first official interest-rate hike since Feb. 1995. In response, many banks raised their prime lending rate to 8.5%.

The Impact

MORTGAGES

Rates have already risen, anticipating the Fed, but could go higher if markets sense the Fed will tighten credit further.

OTHER LOANS

Business borrowing costs will go up: The prime lending rate rose to 8.5% Tuesday from 8.25% as banks followed the Fed’s lead.

BANK CDs/MONEY MARKET FUNDS

Savers haven’t yet shared much in higher rates, but that should change--slowly--in coming weeks. Yields on money market funds should rise quickly.

STOCKS

Many analysts expect prices to continue to weaken in the face of higher interest rates, though a strong economy could support healthy corporate profits, underpinning stocks.

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Source: Times research