Fed Could Pave Way to a Rate Increase

Stock and bond markets face a big test this week as Federal Reserve policymakers gather to take what may be their first step toward tighter credit in the reviving economy.

The Fed, scheduled to meet Tuesday, is expected to keep its benchmark short-term interest rate at the current 40-year low of 1.75%.

But in their official statement after the meeting, Fed Chairman Alan Greenspan and peers are widely expected to shift their “bias” on rates to neutral--paving the way for higher rates later this year.

The central bank, which slashed short-term rates 11 times last year to ease the economy’s pain in the first recession since 1991, has increasingly signaled that it believes the economic downturn is over. Indeed, this month Greenspan declared that a recovery is “well underway.”

But he and other Fed officials also have been careful to say that they believe the economy still is fragile and that the rebound may not be robust.

For that reason the Fed is expected to go slow in raising rates, even though some economists say that at 1.75%--the Fed’s target for the so-called federal funds rate, the overnight loan rate among banks--money costs are at artificially low levels.

In a nod to the economy’s turnaround, however, the Fed is likely to change its official bias on rates to neutral. That would mean the Fed sees the risks to the economy as evenly balanced between growth that is too strong (possibly threatening higher inflation) and growth that is too weak, or negative.

Over the last year the central bank has viewed the primary risk as one of further economic weakness.

A Reuters news service poll of major Treasury bond dealers Friday found that 19 of 24 dealers expect the Fed to change its bias to neutral at Tuesday’s meeting.

But the earliest any of the dealers expect a rate increase by the Fed is May. And most believe the central bank will seek to avoid raising rates before late summer, to give the economy ample time to get going.

Stock and bond markets will be looking closely at the Fed’s choice of words in Tuesday’s statement for signs that policymakers may be considering a rate increase sooner rather than later, analysts said.

The stock market in recent weeks has largely embraced the idea that the economic revival is real and that the Fed won’t snuff it out.

Last week the Dow Jones industrial average hit its highest levels since June, closing Friday at 10,607.23. The Dow is up 5.8% year-to-date.

Among broader indexes, the rally in the Standard & Poor’s 500 in recent weeks has left it up 1.6% this year.

The technology-heavy Nasdaq composite, however, remains in the red, down 4.2% year-to-date after slumping 3.2% last week to close Friday at 1,868.30.

In the bond market, yields on longer-term Treasury issues have surged in recent weeks, taking their cue from strong economic data.

The yield on the 10-year T-note, a benchmark for mortgage rates, rose last week to its highest level since midsummer. It closed Friday at 5.33%.

Investors often begin to bail out of Treasury bonds--pushing yields higher--well before the Fed raises short-term rates, analysts note. But some argue that a weak economic recovery could put a low ceiling over both the Fed’s key short-term rate and over long-term bond yields for most of this year.

Meanwhile, business and consumer borrowers could benefit if the Fed keeps its key rate at 1.75% for now: Most banks peg their prime lending rates 3 percentage points above the federal funds rate. So the prime now is 4.75%. Many consumer loan rates, such as home equity credit line rates, are pegged to the prime.