THE Federal Reserve Board decision to raise short-term interest rates another half-point this week has been received by most in the financial community as a needed adjustment inside a steadily growing economy.
Short-term rates had been falling for several years, prodding the economy out of a recession and slow growth. Recent more rapid growth prompted the higher rates as an effort to stave off inflation.
There is an indeterminate lag between Fed policy shifts and their overall impact on the economy. Consumers pay more immediately in home equity loans, car loans, and some credit card interest payments, as the quick increase in the prime rate indicates. However, rising consumer confidence may be part of the reason the Fed felt comfortable acting this week. The bulls on Wall Street have remained bullish.
The Fed's goal is to have interest rates that are ``neutral'' or ``accommodating'' to modest economic growth. The new rates may not accelerate growth. Millions of Americans have already taken advantage of low interest rates in buying or refinancing homes and cars. But the rates are not expected to do severe damage to the recovery. The rise may even prompt some who have not taken advantage of current low rates to borrow now.
One explanation for the increase is that lowering or keeping rates stable would require so much creation of money, so much underwriting of bank reserves used to buy government bonds, that the resulting liquidity would trigger inflation. The higher rates, in fact, may be the bill coming due for the Fed's having helped strengthen the financial position of commercial banks, following the $200 billion savings-and-loan bailout, which forced the Fed to sell enormous amounts of Treasury paper and low-cost bonds.
Having raised the discount rate, Fed Chairman Greenspan and his colleagues still have a tough decision to make soon: Do they further shore up the bond market by raising the short-term cost of money - and do real damage to the recovery? Or do they keep the short-term rates down - and thus risk inflation in the long term?
For the Fed to indicate and the White House to concur that rates will remain stable and the economy will grow carries a risk. The Fed also must concern itself with the dollar's value on foreign-exchange markets. If foreign investors take Washington's signals to mean that they can get a better deal elsewhere, the Fed might feel forced to raise rates again, just to keep foreign speculators interested.