Why an interest-rate hike by Fed may miss mark

When former Congressman Henry Reuss spoke two decades ago, Federal Reserve officials really listened.

He hopes they will also do so now.

The Wisconsin Democrat was chairman of the powerful House Banking Committee. At least twice a year from 1975-81, Fed chairmen reported politely to him and other committee members.

The Fed is a creature made by Congress, and Fed officials know it. Indeed, the last major reform of the Fed was pushed through Congress by Mr. Reuss in 1977.

Long retired and living near San Francisco, Reuss today has this message for Fed policymakers when they meet tomorrow in Washington: Don't raise short-term interest rates.

"The Fed doesn't need to," he says.

With continuing prosperity and low unemployment, young, less-educated blacks and Latinos have been getting jobs. "It seems to me silly to send them back on the streets again," he says in a phone interview.

Should the Fed raise interest rates, its goal would be to prevent a revival of inflation by slowing the economy. But less demand and output also can boost jobless rates and make it harder for workers to get raises.

Many Wall Street analysts say the Fed tomorrow will hike short-term rates 0.25 percentage points to 5.25 percent. After knocking 0.75 percentage points off rates last fall to ease a global financial crisis, the Fed took back 0.25 percentage points June 30.

But the behavior of prices in July gives Fed officials less excuse for raising rates again.

Consumer prices rose a mere 0.3 percent. Producer prices were up only 0.2 percent.

There's no price inflation, declares Reuss. Nor is there any wage inflation. "If there is any inflation, it is in the stock market."

The "irrational exuberance" in the stock market has concerned Fed Chairman Alan Greenspan since December 1996. Indeed, the Fed has an economic model which finds stocks 48 percent overpriced.

To deal with the stock boom, Reuss argues that the Fed should revive a policy instrument it has not used since 1974: a change in margin requirements. There has been a surge in loans by investors to buy stock.

These "margin loans" let investors use stock holdings as collateral to borrow their way into more share purchases. Under current Fed rules, investors can borrow up to 50 percent of the value of their stocks.

This can be risky. Should the value of stocks in an investor's account plunge below that 50 percent level, brokerage houses will send out a "margin call." Investors facing such calls must provide extra cash, or sell stock, perhaps creating a downward price spiral.

The Financial Markets Center says margin debt ballooned by 13 percent in the second quarter of this year alone. As a percentage of the total value of all stock in the US, margin debt has reached its highest level since September 1987 - just before the October crash.

Reuss would like the Fed to dampen stock market speculation by raising the margin requirement, rather than by a general boost in interest rates.

"Why fire the blunderbuss when a rifle shot will do the trick," he says. The longer the Fed lets investors borrow to buy more fancy-priced stocks, the bigger the chance shares will "go kerplunk" - as in 1929 or 1987.

Reuss also calls on Mr. Greenspan to recognize the legal obligation of the Fed under a 1946 law to "maximize employment," and not just battle inflation. Yet he does give Greenspan credit for today's low jobless rate.

(c) Copyright 1999. The Christian Science Publishing Society

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