The cost of borrowing inching up

Mortgage rates in the US increase, and short-term rates rise overseas.

Want to borrow money in New Zealand? The interest rate is more than half a percentage point higher than in January. Europeans are facing similar bank-account-sapping news. And in the US, a 30-year fixed-rate mortgage now costs at least a third of a percentage point more than in January.

It's all part of a major shift taking place in the global economy: Borrowing is becoming more expensive.

In Europe and other foreign industrialized countries, central banks are raising rates to try to keep inflation down as their economies become more robust. This may limit their economic growth later this year or next year.

In the US, the cost of home loans, corporate loans to build new factories, and interest expense on the federal deficit has hit the highest level in about a year. Economists worry that long-term rates will move even higher. This could prolong the downturn in the housing market and cast doubts on the future direction of capital markets. Last week, the Dow Jones Industrial Average lost 243.72 points.

"Broadly speaking, higher interest rates will weigh on economic growth," says Mark Zandi, chief economist at Moody's Economy.com. "You could argue that higher interest rates reflect a better economy, but the catalyst goes beyond that: It's all part of a global trend of sopping up liquidity."

Money became relatively inexpensive after the dotcom bust, which began in 2000, and the subsequent recession. In the United States, the Federal Reserve lowered short-term rates to as low as 1 percent, and mortgage rates dipped to as low as 4.75 percent.

Rates remained relatively low for several years. "Now, the central banks are taking that away," Mr. Zandi says.

The shifting global landscape coincides with a changing view on Wall Street about the future direction of Federal Reserve policy. "A few months ago, the markets felt there was a 90 percent probability of a Fed rate cut by year-end," says Lyle Gramley, a consulting economist at Schwab Washington Research Group. "Now, there has been a sea change in opinion in the markets where the Fed is headed."

Wall Street now considers it unlikely the Fed will touch interest rates through the end of the year. "The Fed has been saying with great consistency that of the risks it confronts, inflation remains the greatest," says Richard DeKaser, chief economist at National City Corp. in Cleveland. (The Fed views interest-rate policy as a way to keep inflation in check.)

On Thursday and Friday of this week, the government will report the inflation numbers for May. The core Consumer Price Index, which strips out food and energy costs, should come in at 0.2 percent, predicts economist Peter Morici of the University of Maryland School of Business in College Park.

"If we get this, it is above the Fed's target, which means the Fed can't lower rates at this time despite the weak pace of economic activity," says Mr. Morici. "Inflation continues to be a threat."

In fact, the headline numbers – which include food and energy costs – could be significantly higher. Cereal, meat, and poultry are rising in price, reflecting higher prices for corn, which is also used to make ethanol, a gasoline additive. Gasoline prices, which have dropped a bit in the past two weeks, are still averaging $3.09 a gallon nationally.

The consumer might begin to feel the pressure of rising prices, says Eugenio Aleman, a senior economist at Wells Fargo Banks in Minneapolis. "If the consumer slows down in the second and third quarter, that will reduce some pressure on inflation," reasons the economist. "They could be a helping hand for the Fed."

For the past several years, US borrowers have also gotten a hand from foreign investors. For example, in 2004, net capital inflow (funding from foreign investors) exceeded $400 billion, about as high as the budget deficit. "Foreigners paid for all that debt," says Mr. DeKaser. "But that's not happening so much anymore."

Instead of concentrating on US dollars, many foreign central banks are starting to diversify their foreign-exchange holdings with "baskets" of currencies such as euros, pounds, and Australian dollars. "Foreign capital flows appear to be waning somewhat," says DeKaser. "If there are fewer buyers, our rates will have to rise to attract foreign capital."

Rising interest rates will not help the beleaguered housing industry. Thirty-year fixed-rate mortgage rates are now up to about 6.53 percent, after being at 5.25 percent in mid-2003. Last week, the National Association of Realtors (NAR) predicted they would rise to about 6.6 percent and remain at that approximate level in 2008.

Last month, sales of new homes rebounded. But this was mainly because builders gave large discounts. "Rising interest rates reduce the likelihood we are going to hit the bottom anytime soon," DeKaser says.

Last week, the NAR also predicted that median prices for existing homes would fall this year by about 1.3 percent to $219,100, before rising 1.7 percent next year.

Rising long-term interest rates could also have an impact on the US Treasury. The total US debt is now close to $9 trillion. The resulting net interest is estimated at $260 billion in the upcoming federal budget for fiscal year 2008. The Congressional Budget Office estimates that the 10-year Treasury note will be at 5 percent for next year. But it closed on Friday at 5.12 percent after moving as high as 5.25 percent in wild trading.

"With interest rates rising, it's going to be more than planned for earlier," says Stanley Collender, a managing director of Qorvis Communications in Washington and a budget expert.

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