Fed Hikes Interest Rates Moderately to Deter Inflation

The Federal Reserve Board launched a preemptive strike Tuesday designed to ward off increased inflation pressures later this year, nudging short-term interest rates up by a quarter of a percentage point in the first such rate hike in more than two years.

In a modest step, the board’s policymaking Open Market Committee boosted its target for the federal funds rate--the interest that commercial banks charge each other on overnight loans--to 5.5% from the 5.25% level that had prevailed since January 1996.

The increase, which many analysts expect will be followed by similar increases at committee meetings in May and July, is expected to spread quickly through the economy, affecting everything from the prime lending rate charged by banks to interest on credit cards, auto loans and home mortgages.

The Federal Reserve said in a statement that the action was taken “in light of persisting strength” in the economy, which it said “is progressively increasing the risk of inflationary imbalances developing . . . that would eventually undermine the long expansion.”

Ironically, the action comes at a time when inflation is at a 30-year low, with wage increases firmly in check and no major economic distortions seeming to threaten the six-year economic expansion.

However, Fed Chairman Alan Greenspan has warned that, with the economy continuing to grow rapidly far longer than anyone expected, wage pressures are likely to heat up again late this year or early in 1998 and the Fed must move now to have an impact by this autumn.

Greenspan had been warning for weeks that Tuesday’s rate hike might be coming. Although some members of the 10-person Open Market Committee had been reluctant to raise rates, enough of them went along in the secret ballot to enable Greenspan to prevail.

The Federal Reserve launched a similar preemptive strike in 1994, with widely acclaimed success. Not only did inflation subside in the wake of the central bank’s action but the economy continued to grow.

Analysts said that the central bank’s announcement contained two basic messages: First, it believes the economy is growing at an unsustainable pace and, second, the key to continuing the expansion is to make sure that inflation is held in check.

Reaction in the nation’s financial markets, which had expected the move, was mixed. The Dow Jones industrial average initially rallied after the Fed announcement but then sold off, ending down 29.08 points at 6,876.17.

The yield on 30-year Treasury bonds, regarded as a benchmark for long-term interest rates, fell early in the day but rose immediately after the Fed’s action, closing at 6.97%, up from 6.92% on Monday and near a six-month high.

A few minutes after the central bank’s announcement, several of the nation’s major banks, including Citibank of New York, boosted their prime lending rates--the interest they charge their most credit-worthy corporate customers--to 8.5% from 8.25%. More banks are expected to follow suit.

Increasing the federal funds rate amounted to the smallest step that the Fed could have taken to carry out its long-awaited preemptive strike. The panel left the discount rate--the interest the Fed charges on its own short-term loans to banks--unchanged at 5%.

Economists generally supported the central bank’s move, arguing that there was little risk it would plunge the economy into a recession, while asserting that it would keep inflation low.

Allen Sinai, president of Primark Decision Economics, said that--if the Fed had not tightened now--it would have had to administer harsher shock treatment later that might have pushed the economy into recession. “It’s better to do it this way,” he said.

However, most analysts, including Sinai, expect the Federal Reserve to engineer further rate hikes over the next several months, raising the federal funds rate another quarter of a percentage point in May or July and continuing to tighten through most of the summer.

A. Gary Shilling, who runs his own economic forecasting service, predicted that--unless consumers cut back on their spending somewhat in coming months--the Fed probably will continue to raise interest rates indefinitely, even if the action risks a recession.

As is customary in such instances, the Clinton administration offered no public reaction to the move. Treasury Secretary Robert E. Rubin said only that the administration “recognizes and respects the independence of the Federal Reserve.”

“Our economy continues on a healthy and balanced course, with low unemployment, strong job creation and low inflation,” Rubin declared in a joint statement with Janet L. Yellen, chairwoman of the president’s Council of Economic Advisers.

However, liberals in Congress castigated the central bank. Sen. Tom Harkin (D-Iowa), a frequent Federal Reserve critic, warned that the rate boost would slow the economy and reduce tax revenues, making it more difficult to balance the federal budget.

And Rep. Maurice D. Hinchey (D-N.Y.) issued a statement charging that the Fed “has recklessly jammed its foot on the brakes of the economy.” He warned that the central bank was deluding itself into “fighting the ghost of inflation.”

The Fed also drew some brickbats from business groups, which questioned the need to raise interest rates now, given that there are so few signs inflation is likely to rise any time soon.

“Clearly the pressure to raise rates came from the brokerage houses on Wall Street, not from the small businesses on Main Street,” said Martin Regalia, chief economist for the U.S. Chamber of Commerce.

The National Assn. of Manufacturers issued a similar statement, calling the Fed’s move “unwarranted” and warning that it ultimately would be judged to be a “regrettable and serious mistake.”

Tuesday’s tightening marked a reversal of the central bank’s previous policy actions. Since mid-1996, the central bank has been steadily easing its money and credit policies. Greenspan began signaling the latest shift in mid-December, in speeches and testimony before Congress.

* WIDE IMPACT: A look at what the Fed’s action means for borrowers, savers, investors and the economy. D1