After increasing short-term interest rates by a quarter of a percentage point five times since June, Federal Reserve policy-makers will today raise rates by half a point to ambush inflation and slow an economy that's refused to be tamed, economists predicted yesterday.
Both businesses and consumers are sure to feel the pinch as their monthly payments on short-term loans go up. But economists and other finance experts say the steeper rate increase is needed to preserve prosperity and keep inflation at bay.
"I'd be more concerned if they didn't tighten credit by a half point," said Mark Zandi, economist for RFA Dismal Sciences, an economic consulting and forecasting firm based in West Chester, Pa.
"The market's expectations are for the half-point increase."
Federal Reserve Chairman Alan Greenspan has been an avowed inflation fighter during his tenure at the central bank. And, since this round of rate increases started June 30, he has been applauded for his "gradualism" - that is, his willingness to take rates up slowly, so that he doesn't topple stocks or accidentally push the economy into recession. In recent weeks, however, a bevy of troubling reports has ignited a fear that the Fed is actually behind the curve in its battle against inflation. The recent Consumer Price Index report found that prices are rising; a jobs report showed that unemployment is at record lows while labor costs are rising; and a worker-productivity report spawned worries that Corporate America's productivity march had slowed to a leisurely stroll.
Some economists, a minority, believe that the Fed will stick with its incremental quarter-point increases, arguing that anything larger could jolt investors not only in the United States but also in countries still trying to emerge from the global financial crisis of 1997-1998.
"Having overseen the greatest economic expansion in history, Fed Chairman Greenspan isn't about to jeopardize an impressive record by sending panic through financial markets with a disruptive and maybe unnecessary bold move," said Richard Yamarone, an economist at Argus Research Corp.
Raising short-term interest rates is one way to slow a thundering economy. As rates climb, stocks surrender some allure to less-risky investments such as bank certificates of deposit - dropping stock prices and reducing the ability of consumers to spend.
But a key goal of the rate increases is to boost borrowing costs, since borrowed money effectively multiplies an economy's "money supply" - the amount of money available for spending.
Rate boosts by the Federal Reserve directly increase borrowing costs for shorter-term loans, said Gary Geisel, group manager of the Consumer Banking Division for Provident Bank in Baltimore.
Geisel said rates for home-equity loans, business loans, some credit cards and auto loans are often tied to the prime rate, the interest rate that banks charge their best customers. The prime rate is now 9 percent. Since that important benchmark rises or falls by the same amount the Fed alters interest rates, a half-point increase by the central bank will take the prime rate to 9.5 percent - a level last reached Jan. 2, 1991, said Joe Cicero, chief operating officer for First Mariner Bank in Baltimore.
If Greenspan and the Fed subsequently decide that rates must go higher still to slow the economy, the prime rate could hit 10 percent by later this year - a point last touched Jan. 8, 1990. That's nowhere near the 21.5 percent the prime rate hit in December 1980. But a prime rate of 9.5 percent should let some air out of the economic bubble, while a rate of 10 percent should leave both businesses and consumers doing a double take before they spend, Cicero said.
"If the prime rate hits 10, it will have a big impact," he said.
To see how the prime rate operates, consider a revolving credit line that businesses routinely use to finance inventory or other short-term cash needs. Even at prime, a business with a $100,000 credit line in use will see its monthly interest payments rise from $750 to $792 if rates escalated from 9 percent to 9.5 percent. That's an extra $500 in annual costs that, in today's competitive economy, a company probably can't recoup by raising the prices it charges its customers, Cicero said. What's more, with other prices seeming to be on the rise, it's likely that $500 in extra interest expenses isn't the only cost increase the business faces.
The story is the same for the consumer with a home-equity line of credit.
On a $20,000 credit line advanced to the borrower at prime, a rise in rates from 9 percent to 9.5 percent means that monthly cost alone jumps by $8 per month - from $150 to $158.
That's only $8 a month, but it's the cumulative effect of the Fed's rate increases that really packs the punch. In the round of interest-rate increases that began last year, the prime rate has swollen to the current 9 percent from its nadir at 7.75 percent.
On that $20,000 credit line, that made for an increase in monthly interest payments from $129 to $158 - a $29 per month jump that increases a household's annual expenses by nearly $350. And the average home-equity line is more like $30,000, Cicero said.
Mortgage rates don't react to the Fed's machinations - they advance or decline in anticipation of the central bank's rate changes, economists say. And rise they have, since the markets have "already taken into account" the expected half-point increase by the Fed, said Greg Pappas, vice president of secondary markets for Susquehanna Mortgage Corp. in Woodlawn. Six months ago, a 30-year fixed-rate loan with one point (one percent of the loan's value at closing time) featured an interest rate of 7.625 percent. Today, that same loan carries an interest rate of 8.625 percent, Pappas said. That aggregate increase has taken the principal-and-interest payment on a $100,000 mortgage up by $70 per month: from $707.79 at its low point to $777.79 today.
Financial forecasters are saying that this benchmark mortgage rate will likely eclipse the 9 percent level before Fed policy-makers believe that the economy has slowed enough to let them halt their interest-rate campaign.
"It's going to be tough" for consumers and business owners to swallow the increase in expenses, said RFA's Zandi. "But the Fed has got to slow the economy down."
The Associated Press contributed to this article.