Fed Must Weigh Conflicting Forces in Rate Decision

By PETER G. GOSSELIN

Aug. 24, 1999 12 AM PT

TIMES STAFF WRITER

WASHINGTON —

The U.S. economy has blown past so many gates in its long, upward arc that many people--perhaps even some at the Federal Reserve--have a hard time believing that it may now be slipping off course.

That, coupled with the absence of clear signs of economic wobble, will make it all the harder for the Fed to decide today whether to raise interest rates to bring the economy into a steadier, if somewhat lower, orbit.

“We’ve had unexpectedly strong growth and unexpectedly low inflation, and the Fed has to decide which unexpected trend is going to give out first,” said Jeffrey Frankel, a Harvard University economist and a former member of President Clinton’s Council of Economic Advisors.

The near-universal betting is that the Fed is more worried about inflation and that it will raise short-term interest rates a notch for the second time this year. That would lift the federal funds rate, at which banks make short-term loans to one another, from 5% to 5.25%, its second quarter-point increase of the year.

What effect that will have is anybody’s guess, a point driven home Monday when the nation’s stock and bond markets did exactly the opposite of what economic theory says they should do in the face of the rate hike.

Stocks, which should tumble on worries of slower growth, instead leaped ahead. Bond interest rates, which should rise with inflation concerns, fell.

“It’s an Alice-in-Wonderland reaction,” said David M. Jones, chief economist with Aubrey G. Lanston & Co. in New York. ‘It’s the kind of thing you’d expect from a speculative market when not even the prospect of a Fed rate hike gets in the way of the party.”

In fact, analysts said, Monday’s jump in stocks illustrates one of the defining characteristics of the current period and one of the key dilemmas facing Fed policymakers--the heady and sometimes disorienting interplay between financial markets and the economy.

By all rights, according to these analysts, the Fed should be able to nudge interest rates up without much controversy or risk of tipping the economy into trouble.

After all, Fed Chairman Alan Greenspan has made preemptive strikes against inflation by raising rates twice before in the last decade, in 1989 and 1994. And although the earlier increase contributed to a mild recession, the two actions are widely credited with having set the stage for, then extended, the near-record boom of the ‘90s.

In addition, the Fed slashed interest rates by three-quarters of a point in two months last fall to cope with a global financial freeze-up in the wake of Russia’s debt default. But that crisis has passed and, with it, the need for the rate reductions.

Finally, some of the lucky economic breaks the nation has caught in recent years have begun fading, and the economy has begun showing some--although by no means all--of the signs of renewed inflation, the very thing the central bank is charged with controlling.

Oil prices, which tumbled in the midst of the Asian financial crisis, have doubled since January. The cost of imported goods, which Americans have been picking up at bargain basement prices because of the strength of the U.S. dollar, is on the rise again. So, finally, are working Americans’ wages, which remained remarkably tame until recently despite generation-low unemployment.

In ordinary circumstances, a Fed rate hike would be a foregone conclusion as “insurance,” said James W. Coons, chief economist of Huntington Banks in Columbus, Ohio. “In their minds, the tight labor market is a ticking time bomb.” Raising rates and slowing growth is the way to defuse it.

The central bank has been cautious about acting, in part because the evidence of renewed inflation is meager and in part for fear of knocking the record-high stock market out of bed.

“If the Fed wants to make sure the market doesn’t shrug off its action like last time, it’s going to have to do something mildly dramatic,” said Jones, the New York economist. “Something that surprises the market.”

That could mean combining a fed funds rate hike with an increase in another Fed-controlled rate or the announcement that the central bank is tilting in favor of further fed funds rate increases.

When Fed policymakers met on June 30, they did, in fact, tighten policy, pushing up the federal funds rate from 4.75% to 5%. But they coupled the move with the unusual announcement they were no longer tilting toward further increases--dampening the impact of the move.

Raise Rates or Do Nothing?

Here are some of the issues that may be part of the Federal Reserve’s debate as it meets today to consider raising short-term interest rates for a second time this summer. The Fed’s first increase was announced at its June 30 meeting. A look at then and now:

Issue: U.S. stocks

Status June 30: Dow at 10,815, Nasdaq at 2,642

Status now: Dow at 11,299, Nasdaq at 2,719

Potential Fed view: Despite recent pullback, market may be overheated.

Issue: U.S. dollar

Status June 30: Worth 121 yen

Status now: Worth 111 yen

Potential Fed view: Weaker dollar could boost inflation via higher import prices.

Issue: Long-term interest rates

Status June 30: 30-year Treasury at 6.06%; KDP junk bond index at 9.88%

Status now: 30-year Treasury at 5.98%; KDP junk bond index at 10.34%

Potential Fed view: Despite recent drop in Treasury yields most bond yields are higher, which could help slow economy.