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Fed expected to raise interest rates today

Published Oct. 1, 2005

Even though inflation shows no signs of worsening, the Federal Reserve apparently is preparing to raise interest rates for the first time in two years.

Fed Chairman Alan Greenspan seems bent on pre-emptive action _ the economic equivalent of firing before the enemy actually gets to the battlefield.

The nation's inflation rate is actually lower so far this year: 2.3 percent for January and February compared with 3.3 percent for all of last year.

But based on Greenspan's public statements, economists believe a quarter-point increase in short-term rates is the nearly certain result of today's meeting of the Federal Open Market Committee, the central bank's monetary policy arm.

In congressional testimony last week, Greenspan stressed the "importance of acting promptly _ ideally pre-emptively _ to keep inflation low."

"If this is not the handwriting on the wall, I don't know what is," said economist Sung Won Sohn of Norwest Corp. in Minneapolis.

After a rally in the bond market, the Dow Jones Industrial Average rose 100 points Monday, wiping out more than half the losses that had piled up during the previous two weeks of guessing that the Fed would raise interest rates. The Dow closed Monday at 6,905.25.

If all goes as anticipated, the Fed will drain reserves from the banking system, pushing the rate charged among banks on overnight loans from 5.25 percent to 5.5 percent. It will be the first increase since Feb. 1, 1995.

In response, lenders are expected to nudge the prime rate they charge their best business customers from 8.25 percent to 8.5 percent. And millions of American consumers with short-term loans _ everything from auto loans to credit cards to adjustable-rate home mortgages _ will have to pay more, too.

As a result, six months to a year later, economic growth should slacken a bit. That, in turn, should accomplish the Fed's intended result: a small reduction in the economic pressures _ drum-tight labor markets, red-hot demand for raw materials _ that exacerbate inflation.

That's the theory _ applauded by many economists, panned by some. The Fed first tried it in 1994. Starting in February of that year, it doubled the overnight interbank rate from 3 percent to 6 percent, in seven steps over a 12-month period.

"It was very revolutionary and absolutely correct," said economist Allen Sinai of Primark Decision Economics in New York. "In the old days, interest rates weren't raised until the whites of the eyes were there, until inflation was rising, and it was always too late."

The result of the new policy: contained inflation and sustained economic expansion. Growth slowed from 3.5 percent in 1994 to 2 percent in 1995, before increasing to 2.4 percent in 1996.

As counterintuitive as it seems, an early growth-slowing increase in interest rates is aimed at extending the expansion, which began its seventh year this month.

"Once inflation begins to accelerate, it's much more difficult to get it back down without a recession," said economist Paul W. Boltz of T. Rowe Price Associates in Baltimore. "Now is the time to just very lightly tap on the brakes."

But other analysts _ and the Clinton administration in its 1997 Economic Report of the President _ argue it would be more risky to slow economic growth prematurely than to allow a modest rise in inflation.

"Right now Greenspan wants to pre-empt on the basis of a projection no one is sure is right. That doesn't lead to good policy," said economist Donald Ratajczak of Georgia State University.

"We're deeply concerned that a rise in interest rates will choke off . . . growth . . . and all those people . . . who haven't had an opportunity to take part in it, will be denied that opportunity yet again," said Rep. Maurice Hinchey, R-N.Y.

But Greenspan said the long lag between changes in interest rates and their impact on the economy dictates a policy of pre-emption.

"We have no choice but to forecast and act on a forecast," Greenspan said. "Unless we do that, we will be behind the curve a good deal of the time."