Yes, higher interest rates do have an effect

While some wonder if Fed moves can slow the red-hot economy, others say they're working - and may go too far.

By , Staff writer of The Christian Science Monitor

The Federal Reserve will succeed - in fact it may have already succeeded - in braking what it sees as a runaway US economy.

True, a common view lately is that the Fed's moves to raise interest rates are doing little to slow an economy that has been moving like a photon down a fiber-optic cable.

Even on the Fed's policymaking committee, there has been talk that the next rate hike may need to be by half a percentage point, not the modest quarter-point moves the agency favored of late.

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But recent government statistics suggest that the monetary tightening is already having its intended effect. Indeed, some economists have concerns that an overzealous Fed or other factors could actually push the economy into recession.

Already, higher interest rates are biting into many Americans' pocketbooks. A bigger downshift in the economy would reach broadly into everything from jobs and home values to the health of financial markets - even the outcome of this fall's presidential election.

"Growth is slowing as sure as spring is arriving," says Gordon Richards, chief economist of the National Association of Manufacturing in Washington.

Last Friday, the Commerce Department reported a decided drop in new orders for durable goods, such as refrigerators, in February. That was the second consecutive monthly decline. Other indicators last month of a slowdown include smaller gains in industrial output and fewer new jobs.

The Fed's intention is to slow business activity only modestly - enough to avoid any buildup of price inflation. And so far, most economists expect this kind of "soft landing" for the bustling economy. The Fed began raising rates last summer, and typically, it takes nine months or so for such moves to be seen in statistics.

The nation's output of goods and services, or gross domestic product, grew 4 percent after inflation in 1999. The Fed sees a roughly 3 percent pace as sustainable.

The sense of urgency - including talk of half-point rate increases - stems in part from the economy's bristling pace in the fourth quarter of 1999, when it grew at a 6.9 percent annual rate.

Clamping on the brakes hard would cause a recession - an actual drop in national output over six months or more.

But even the Fed's "drip, drip, drip" restraint, if it goes too long, could turn a slowdown into a bad slump, say Mr. Richards and other economists such as James Galbraith of the University of Texas, Austin.

Here's how such a "hard landing" could affect all jobs, family incomes, corporations, and the election:

Jobs. The less-skilled and less-educated will have a tougher time finding work. And they would bear the brunt of layoffs.

Also hurt will be blacks and Hispanics, single mothers trying to move off welfare, and other low-income individuals.

"There is no reason to think that the rule of last-hired, first-fired won't prevail when we hit a downturn," says Jared Bernstein, an economist at the Economic Policy Institute, a liberal think tank in Washington.

Families. Households, especially those in the middle- to lower-middle income range, would find their available spending money shrunk by higher interest charges on car loans, credit-card debts, and home mortgages with variable interest rates. (Those low on the income ladder have less access to credit - and a smaller interest burden.)

Household debt rose 9.4 percent last year to hit an extremely high level, notes Jane D'Arista, an economist at the Financial Markets Center in Philomont, Va.

Corporations. Profits would be hit. This would likely hurt stock prices, and thus many well-to-do citizens. Interest-sensitive industries, such as housing, automobiles, and durable goods would be struck first.

Especially hard-hit would be companies heavily reliant on rapid growth - such as retail chains opening new stores at a fast clip, says Robert Solow, a Nobel Prize-winning economist at the Massachusetts Institute of Technology in Cambridge.

The fall election. Democratic presidential candidate Al Gore could lose votes.

"Gore is running on the long boom," notes Mr. Galbraith. Political analysts figure the status of the economy in the half year before a presidential election is highly important to the outcome, with a strong economy favoring the incumbent party.

In 1980, Jimmy Carter lost his reelection bid due to a number of factors, including a sagging economy. Short-term interest rates hit 20 percent under an unusually active Fed.

This year, MIT's Mr. Solow cheers the Fed's monetary gradualism - five small hikes in interest rates since last summer - as appropriate. Better, he says, than "letting the economy rip and having to bring it down in a hurry later," as occurred in 1980.

But whether fast or slow, "weaning an economy from years of easy money ... is very tricky," notes Michael Cosgrove, an economist at the University of Dallas in Irving, Texas.

One risk is that consumers become real skinflints. Short-term interest rates have already risen 1.25 percentage points. Thirty-year fixed-rate mortgages are now well above 8 percent.

When rates go up 1 percentage point, the extra debt payments drain an extra $569 per year from the typical indebted household that earns $25,000 to $50,000 a year, the Financial Markets Center finds.

Another risk is that the slowdown will clobber stocks. Almost half of American households own at least some shares nowadays.

Fed Chairman Alan Greenspan says the positive "wealth effect" of the booming stock market has been boosting GDP by 1 percentage point a year, as consumers feel free to spend. A market bust, analysts presume, would dampen economic prospects decidedly.

Ms. D'Arista points to other less-discussed risks:

1. House prices, which have soared in areas such as New England and Silicon Valley, could plummet as they did in 1990-91.

2. Foreign investors have financed a huge deficit in US international payments - $335 billion last year. If a stock market drop causes foreign investors to slow or reverse their investments, it would drive interest rates higher - worsening the downturn. An outflow could also weaken the dollar, adding to inflation as the costs of imports rise.

3. A group of international banks has been engaging in what is termed the "Euro carry trade." They borrowed the European currency cheap, exchanged them for billions of US dollars, and bought higher-interest bonds. These bonds are used to finance low-cost mortgages. Such highly leveraged, profit-seeking fads, if they backfire, can cause damaging financial turbulence.

(c) Copyright 2000. The Christian Science Publishing Society

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