Wednesday, June 30, 2004

Fed poised to raise rates

Step-by-step series of interest increases likely start today

By John Byczkowski
Enquirer staff writer

Dennis Hutzel, 77, of Mount Healthy, is thrilled about rising interest rates. He says low rates means he's been earning next to nothing on his savings.
The Federal Reserve is expected to raise interest rates today for the first time in more than four years.

Yet today's expected quarter-point rise in the federal funds rate will hardly be noticed in an economy that's growing and creating jobs, economists say.

What's important is the next increase - and the next one and the next.

Economists say they believe today's action will be followed by increases at each of the Fed's meetings for the rest of 2004 and likely into 2005.

This shift in policy ends 12 months of the lowest interest rates in 46 years, and four years in which the Fed kept rates low to nudge the economy upward.

How consumers and businesses will react is anyone's guess.

But Dennis Hutzel of Mount Healthy, for one, is thrilled. The 77-year-old retiree said low interest rates mean he earns next to nothing on his savings.

"It's similar to renting your house," he said. "The people who are renting my money are paying me no rent at all."

Because of that, he and his wife have had to cut their spending. "I used to give a reasonable amount to charities. We've cut way back," he said. "We haven't taken vacation in quite some time."

The Fed signaled a rate increase after its May 4 meeting. Acknowledging a growing economy and the disappearance of any threat of deflation, the Fed said it would begin to raise interest rates at a "measured" pace.

"If a 1 percent fed funds rate was right for a recession, it cannot be the right funds rate for the present economic situation," said Anna Schwartz, an economist at the National Bureau of Economic Research in New York.

Economists argue about what the Fed meant by "measured."

The consensus is the Fed will raise interest rates by 0.25 points at each of its five remaining meetings this year, bringing the fed funds rate to 2.25 percent.

And they agree consumers will hardly notice, because the benefits of an expanding economy overwhelm the cost of higher interest rates. "Profits are rising, incomes are rising, and the cost of capital is still very cheap. That's fueling a lot of hiring right now," said Steve Spiwak, senior economist at the consulting firm Retail Forward in Columbus. "If the Fed can keep interest rates neutral, the increase in profits and incomes should outweigh the increase in interest rates and keep things humming along."

Most consumers won't feel the increase "because so many have locked in fixed rates on their mortgages," said Carl Tannenbaum, economist for LaSalle Bank in Chicago. "As rates go up, unless (consumers) move, they won't notice a difference in monthly payments. Most consumers have really done a very good job of managing their indebtedness, and are in a position where the Fed's rate increases should not be too terribly harmful."

Rates already climbing

Savers are already benefiting, as rates on CDs and other accounts are climbing. Rates on 36-month CDs at Fifth Third Bank of Cincinnati have doubled in the past six months, to 3.5 percent from 1.75 percent. "As interest rates start ticking up, it starts to benefit the savers," said Leigh Prop, senior vice president for retail banking at Fifth Third-Cincinnati.

That's welcome news to Hazel Burke, an 87-year-old widow who lives in Groesbeck. She has money in CDs and a savings account, but interest rates have been so low she's earning less than $100 a month on that stash. Her only other source of income is Social Security.

Burke said she only recently stopped doing yard work, and has had to hire someone to mow her lawn. "The interest would really help me keep the house," she said.

A small jump in rates likely won't deter shoppers. Bob Pulte, president of Bob Pulte Chevrolet in Lebanon, said he's seen more people in his showroom recently. "There was a lady in here 20 minutes ago, had her car in for service. Needed new tires," he said. "She said, 'Aw, the heck with it, I think I'll buy a new car,' walked up front and bought a new car. It's just that kind of environment you're starting to see."

If consumers retain that attitude as rates go up, "I don't think two points is going to ruin my life," Pulte said.

While the higher rate won't have much effect short term, economists wonder how consumers and businesses will react once they know interest rates will keep rising.

"Whether there will be effects on home sales, on consumer expenditures, and the usual kinds of responses to high interest rates I think are hard to predict," Schwartz said.

Spiwak, at Retail Forward, said in the second half of this year, home buyers may find a monthly payment has gone up $200 this year - but that's got as much to do with home prices rising at 7 percent a year as with higher interest rates. Because incomes are also rising, rising costs may not discourage many home buyers, he said.

When will it end?

Economists can't predict when the Fed will stop raising rates. Many believe the Fed will stop when rates reach a neutral level - not low enough to push the economy toward faster growth, and not high enough to depress it. That level means the fed funds rate will end up about 2 percentage points above the inflation rate, or about 4 percent, sometime in 2005.

But critic Schwartz said she believes the Fed waited too long to being raising rates, that inflation is a bigger problem than the Fed is willing to acknowledge, and that the eventual target for the fed funds rate will be higher than 4 percent. She believes the Fed has been too complacent about what an extended period of low rates "are really doing to the underlying pressure for price rises."

LaSalle's Tannenbaum said if you believe inflation isn't a problem, "you're essentially betting oil and dairy prices are going to retreat. I'm not sure I'd take that bet right now," he said.

John Lonski, chief economist for Moody's Investors Service in New York, disagrees. "If inflation was that big of a problem, we'd probably see higher long-term bond yields, and a lower dollar exchange rate," he said.

Kenneth Kim, chief economist for investment analysts Stone & McCarthy in Princeton, N.J., said his clients' views are all over the map on what the Fed will do. "Some people are quite concerned the Fed is behind the curve, and they might have to ratchet rates higher than they're saying now," he said. "Other people think that the inflation environment is stable enough still that there might not be as much of a rate increase. ... There's a wide variety of opinion out there of how far the Fed has to go."

What's next

What happens after the Federal Reserve raises the fed funds rate to 1.25 percent from 1.0 percent:

• Banks will raise their prime lending rates. The prime rate is the interest banks charge their best customers, and many consumer rates are tied to the prime. Typically, banks maintain the prime at 3 percentage points above the fed funds rate. The prime rate has been at 4 percent since last June.

• Consumers may not feel this until August. Many banks peg their loan rates to the prime rate as published in the Wall Street Journal, effective the first day of the first month after publication. Though the rate may change today - the last day of June - it won't be published till Thursday, so many banks won't change rates tied to the prime until Aug. 1.

• Because the markets have expected the Fed's move, many interest rates have already inched upward, including those on mortgages and CDs.

• Even fixed-rate credit cards won't be immune to rate increases. Most credit-card companies reserve the right to change card terms with as little as 15 days' notice.


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