Originally created 05/06/04

Federal Reserve sets in motion countdown to higher interest rates



WASHINGTON -- The clock now is ticking to when, not if, the Federal Reserve will begin to nudge up ultralow interest rates.

The view of a growing number of economists that the central bank's first rate increase in more than four years will come this summer solidified Tuesday as Federal Reserve Chairman Alan Greenspan and his colleagues decided to keep a key short-term interest rate at a 46-year low.

In doing so, however, the Fair Market Policy Committee dropped a promise to be "patient" before it starts raising rates.

"Step by step we are getting closer to higher interest rates," said Carl Tannenbaum, chief economist at LaSalle Bank.

Tannenbaum and other economists believe Fed policy-makers will raise rates at the Aug. 10 meeting. Some, however, believe rates could start going up as early as the Fed's next meeting, June 29-30. A few, however, don't foresee higher rates until 2005.

The timing of any increase will hinge on what economic data, especially reports on the nation's employment climate and inflation, that come out in the next few months say about the economy, analysts said.

Were the data to come in on the strong side, odds of a June rate increase would rise; if the reports were to depict weaker-than-expected activity, an increase might not come until after November's presidential election or even later, analysts said.

The Fed's main tool for influencing economic activity is the federal funds rate. The funds rate, the interest that banks charge each other on overnight loans, has been at the superlow level of 1 percent since last June.

As a result, commercial banks' prime lending rate for many short-term consumer and business loans has stayed at 4 percent, the lowest level in more than four decades. The prime rate moves in lockstep with any changes to the funds rate. When the Fed leaves the funds rate unchanged, the prime remains the same.

With the economic recovery solidly on track, the Fed dropped a promise it had made at previous meetings this year, in January and March, to be patient before it started raising rates. That was intended to prepare Wall Street and Main Street for higher rates, economists said.

At the same time, however, the Fed sought to let investors and borrowers know they don't intend to ratchet up rates, rather to push them up gradually, analysts said. Fed policy-makers said any rate increases probably will be at a measured pace.

"It is clear to me that what the Fed is signaling is that they will increase rates gradually - not that they won't raise them this year," said Sherry Cooper, chief economist at BMO Nesbitt Burns.

Economists don't expect a replay of 1994, when the Fed embarked on a yearlong series of rate increases that doubled the funds rate. The shock waves from that move triggered a series of financial catastrophes from the bankruptcy of Orange County, Calif., to the Mexican peso crisis.

In contrast, some economists foresee the current federal funds rate, now at 1 percent, rising to about 1.50 percent or 1.75 percent by the end of this year. If so, that would mean the prime rate would go up by a similar amount, from the current 4 percent to 4.50 percent or 4.75 percent by year's end. Even so, the rates would still be considered quite low, analysts said.

"You have to remember: where we are today is at an emergency level of the funds rate," Tannenbaum said. The Fed cut rates 13 times, starting on Jan. 3, 2001, and ending last June, to prop up the economy. During that credit-easing campaign, the economy fell into recession in 2001, was jolted by the Sept. 11, 2001, terror attacks, was hit with a wave of accounting scandals and went to war in Iraq.

The economy, after a long spell of lackluster activity, finally perked up in the middle of last year and recent economic reports indicate it now has good momentum.

Fed policy-makers Tuesday said the economy is "continuing to expand at a solid rate, and hiring appears to have picked up."

Economic growth clocked in at a healthy 4.2 percent rate in the first quarter of this year and is expected to be stronger in the current quarter.

After months of sluggish payroll gains, the economy added 308,000 jobs in March, the most in four years. Economists want to see gains of at least 150,000 net jobs a month to feel that the labor market is truly on firmer footing.

Although some economic reports show inflation creeping higher, the Fed indicated that it is not yet worried, saying "long-term inflation expectations appear to have remained well contained."

On the Net:

FOMC: http://www.federalreserve.gov/fomc/