THE Federal Reserve put the economy on trial and seems to have decided it was guilty of attempted inflation. In sentencing, the Fed was strict - pushing interest rates up by one-half of a percent on Tuesday. It was the fifth increase this year.
The move surprised a few economists who thought the Fed might raise rates by only one-fourth of a percent. After all, it is still hard to find the economy guilty beyond a reasonable doubt. ``The Fed does not like to deal with circumstantial evidence; it likes the smoking gun and it does not have that yet,'' says Paul Kasriel, an economist with the Northern Trust Company in Chicago.
Although there are no blatant signs of inflation, there has been a modest increase in the inflation rate on a year-over-year basis. The Fed also has been nervously watching as commodity prices for lumber, chemicals, and steel, for example, have moved up. Some of these price increases have been offset by lower prices for computers, medical care, and transportation. ``Clearly there is an upward trend, but it does not indicate that there is a major problem,'' says economist Veronika White of First Fidelity Bancorporation in Philadelphia.
The Fed would have been criticized had it not acted, says economist David Hale of Chicago-based Kemper Financial Services Inc. He adds that the rise will keep interest rates at their post-World War II average level of about 1.75 percentage points above inflation - now about 3 percent.
``The actions are intended to keep inflationary pressures contained, and thereby foster sustainable economic growth,'' the Fed said in a statement on Tuesday.
It was a unanimous vote by the Fed's policymaking Open Market Committee, chaired by Alan Greenspan.
The move comes at a time when the economy is still relatively strong. On Tuesday, the Census Bureau reported that housing starts for July rose by 4.7 percent, helped in large part by a 19 percent increase in multifamily housing starts.
The second half of the year will be helped by robust auto production. ``Dealerships are continually complaining not that sales are down but that there are shortages of hot models,'' says Peter D'Antonio, senior economist at Citicorp. ``It should add to the gross domestic product if they stick to their second-half production schedules.''
There are signs that the Fed's earlier tightening is starting to slow the economy down, however. Merrill Lynch economists note that higher interest rates are starting to take their toll on the housing market. Permits to build new single-family houses slumped 1.7 percent last month.
A Dun & Bradstreet Corporation survey of 1,000 manufacturers found that near-term optimism is waning, due in large part to slower growth in new orders and a reduction in order backlogs. The survey found hiring plans for the next three months are off sharply.
Economist Brian Fabbri of Paribas Capital Markets says he worries that the Fed's ``bold move'' is coming at a time when the economy has reached a mature stage. ``What has the Fed done to the American market at a time when consumers are not as well off and have less discretionary income because of higher taxes?,'' Mr. Fabbri asks.
Despite their concerns, economists don't expect the economy to dip back into recession. Instead, they expect the economy to slow to the 2.5 to 3 percent annual growth rate in the second quarter.
The Fed's actions appeared to please the financial markets, which would not mind a slower economy. On Tuesday, the stock and bond markets rose after the announcement. The Dow Jones industrial average gained 24.28 points, closing at 3784.57. The dollar rallied against the Japanese yen and the German deutsche mark.
The markets may have been reacting to the prospect for stable interest rates over the next three months. Economists do not expect the Fed to raise interest rates again until after the congressional elections in November. ``There will be a lot of political pressure to maintain monetary policy for a while,'' Fabbri says.
The Fed indicated it will take some time to see the impact of its actions. It usually takes six to nine months for interest-rate movements to have any effect on the giant US economy. ``The Fed will then want to take a fresh look at the economy and where policy stands when they have new data in,'' Citicorp's Mr. D'Antonio says.
The higher rates will especially hit California, where 60 percent of the mortgages are variable-rate mortgages compared with 15 percent for the country as a whole.