*EPF311 06/30/2004
U.S. Central Bank Action Ends Era of Growth-Boosting Policy
(Transition to higher interest rates managed well, some say) (1220)

By Andrzej Zwaniecki
Washington File Staff Writer

Washington -- The U.S. central bank has raised a key interest rate for the first time in four years, ending a long period of "accommodative," or easy, monetary policy, which has been credited with helping the U.S. and world economies rebound from the recession of 2001 and sluggish growth caused by political uncertainties.

The Federal Open Market Committee (FOMC), the policy-making arm of the Federal Reserve, voted June 30 to raise its key federal funds interest rate -- the rate banks charge one another for overnight loans -- from 1.00 percent, where it has stayed for the past 12 months, to 1.25 percent.

Analysts say the magnitude and pace of U.S. interest rate increases are important to investors in other countries, influencing demand for securities in emerging markets, for example.

The prospect of rising U.S. interest rates coupled with a falling exchange rate for the U.S. dollar threatens to end two years of growth in borrowing by emerging market nations, the International Monetary Fund (IMF) said in a report on global financial stability.

But some analysts say concerns about the impact of higher U.S. interest rates on foreign investments are overblown, especially if the rises are gradual and moderate.

The FOMC decision also will narrow the gap between the U.S. rate and a key European interest rate, which has been held at 2.00 percent by the European Central Bank (ECB) for the past 12 months. This is likely to ease the pressure on ECB officials to reduce the rate set for the 12 countries using the euro currency, according to European economists cited in news reports.

The Era of Easy Money

The FOMC began cutting interest rates in early 2001 in response to economic data indicating slowing economic activity.

It continued to reduce rates after the economy was hit by bursting stock market and business-investment bubbles, a series of corporate scandals, and uncertainties created by the September 11 terrorist attacks and wars in Afghanistan and Iraq. By June 2003, the federal funds rate had gone down to 1 percent, the lowest borrowing cost in 46 years for consumers and businesses alike.

Most economists contend that consumers started buying new houses and cars in record numbers and spending money received from mortgage-refinancing transactions on home improvements, new furniture and appliances in response to the monetary incentive accompanied by President Bush's tax cuts.

The extended period of low interest rates has also allowed companies to refinance high-cost debt and to substitute long-term debt for short-maturity debt to improve their balance-sheet liquidity. As rates kept falling, companies eventually overcame their initial reluctance to borrow money and started investing again.

The FOMC decision signals, however, the likely end of easy credit. Both consumers and businesses must now reconsider their options. The recent rate increase and possible further hikes signaled by the committee in its June 30 statement will put increasing pressure on the most indebted consumers.

Some private economists caution that households may have a hard time paying off huge debts they have piled up during the past four years. But Federal Reserve Chairman Alan Greenspan and other officials have said repeatedly that the high level of household debt is not a major concern. Because of a significant rise in housing prices in recent years, household assets have grown even faster than debt, boosting households' net worth to record levels, they said.

"Many people have gone from being renters to homeowners," Greenspan said in June 15 testimony before a Senate committee. "I don't think their financial condition should be considered worse as a result."

Change Is Coming

In 2003, with the economic expansion accelerating, Federal Reserve policymakers had to deal with an unusual worry. If the economy had followed the usual pattern of business cycles, faster growth would have been accompanied by rising inflation. But due to reasons not yet fully understood, indicators of inflation were going down instead, prompting some FOMC members to comment publicly on a range of options they might consider to keep the economy from sliding into actual deflation -- a widespread decline in prices that may cause recession, rising unemployment and financial stress. At that time, the FOMC said that rates would stay low for a "considerable" time.

In 2004, however, price increases accelerated again, and committee members acknowledged they face the "challenge of making the transition to a policy stance more appropriate for sustained economic expansion," as Federal Reserve Governor Mark Olson put it June 15.

According to an April IMF report, the key challenge for FOMC members was to communicate their intentions "as clearly as possible" to the markets, "thereby reducing the risk of abrupt changes in expectations later on."

An increase in interest rates can be unsettling to financial institutions and big investors if they expected lower rates. It can cause a rapid fall in stock and bond prices as well as bankruptcies.

Managing Market Expectations

FOMC members had shifted their emphasis about the pace of forthcoming rate increases already in 2003. They signaled a possibility of a less accommodative policy but said they could be patient about adopting it.

In June, the core inflation index was up 1.7 percent from a year earlier. Although Federal Reserve Governor Donald Kohn, an FOMC member, said June 4 that this "probably does not represent the leading edge of steadily worsening inflation," he acknowledged being surprised by the extent of the rise. And some private economists argued that higher interest rates were overdue and that FOMC members might have less maneuvering room than they thought they had.

Later in May, the FOMC issued a statement asserting that when it does raise rates, it would do so at a "measured" pace. But Greenspan said June 8 that the committee is "prepared to do what is required to fulfill our obligations to achieve the maintenance of price stability so as to ensure maximum sustainable economic growth" if its assessment of economic conditions "proves misplaced."

Many economists and some FOMC members believe that the committee has managed expectations well, nudging markets toward prices that reflect an expected interest rate increase.

Even back on May 20 Federal Reserve Governor Ben Bernanke said that "because of the impact of private-sector expectations about policy on current long-term rates, a significant portion of the financial adjustment associated with the tightening cycle may already be behind us."

How fast the FOMC will go with further rate increases, if any, is still an open question. Ideally, it should strive for moderate gradual rises to avoid throwing the economy out of sync, said the Bank for International Settlements (BIS), an international organization working to foster cooperation among central banks. In a statement issued on the eve of the FOMC meeting, BIS cautioned that raising rates too fast would very likely entail real economic costs and raising them too slowly could lead to further price and debt increases.

The FOMC said June 30 it believes that, with inflation expected to be relatively low, it will be able to adopt any further rate increases at a pace that is "likely to be measured."

(The Washington File is a product of the Bureau of International Information Programs, U.S. Department of State. Web site: http://usinfo.state.gov)

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