Most expect a fifth Fed interest rate increase

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Interest rates probably will go up Tuesday, whether or not it’s good policy.

Most economists think higher short-term rates are good policy, and that the Federal Reserve should and will raise rates when it meets Tuesday. Their reasoning goes like this: A quarter-point increase in the federal funds rate wouldn’t do much to slow the economy anyway, and everyone expects a rate hike. That’s why the Fed will raise the federal funds rate to 2.25 percent from the current 2 percent.

That’s an oversimplification, but there’s an undercurrent of circular logic that says that investors believe the Fed will raise rates, the Fed has done nothing to discourage such speculation, so the Fed has to meet those expectations or lose credibility. Investors would freak out if the Fed sprang any surprises. Given the choice between freaking out investors or raising the interest rates that consumers pay, the Fed will choose the latter course.

The futures market at the Chicago Board of Trade has priced in a 96 percent chance of a quarter-point increase. It would be quite a shock to those futures traders if the Fed kept rates steady.

The Fed’s Open Market Committee meets eight times a year to decide on interest rate policy. It has raised its target federal funds rate by a quarter-point in each of the last four meetings. The federal funds rate is what banks charge one another for overnight loans to cover reserves.

More important for consumers, the prime rate moves in lock step with the federal funds rate. If the Fed hikes the federal funds rate to 2.25 percent as expected, the prime rate will rise a quarter-point, too, to 5.25 percent. Some types of consumer debt, such as credit cards and home equity lines of credit, go up and down with the prime rate.

Bill Hummer, chief economist for the Chicago-based financial services company Wayne Hummer, feels confident that the Fed will raise rates for the fifth straight meeting on Tuesday, and that the bigger question is whether the central bank will raise again in January or take a breather then.

Hummer says a quarter-point increase doesn’t make much of a difference to the economy right now, but the Fed is on a journey comprising small steps. The Fed is focusing on its destination, not on every footfall on the way. The destination? Hummer won’t guess beyond 2005, but he thinks the federal funds rate will average 3.2 percent in the fourth quarter of next year — ending 2005 at 3.25 percent or possibly 3.5 percent. That would mean that the Fed would raise rates in four or five meetings next year, and stand pat three or four times.

Fed officials, Hummer says, “continue to enunciate fairly often that basically the structure of short-term interest rates is too low, given the place in the cycle we’re in.” These officials worry that rates are too low to prevent a recurrence of inflation. “They don’t want to be in a position of looking back and saying they should have acted sooner,” Hummer says.

Anthony Liuzzo, professor of business and economics at Wilkes University in Wilkes-Barre, Pa., says the Fed is trying to send a signal “that this is the economy that continues to be strong, it’s continuing in the recovery process after its downturn a couple of years ago, that it has confidence that overall the economy is moving forward. The Fed is probably accurate about that as well.”

Liuzzo makes an annual forecast of retail sales during the holiday shopping season, and he believes that this year’s sales growth won’t be as strong as last year’s. “It won’t be a bad year for anyone, certainly,” he says, with same-store sales growth on the order of 3 to 3.25 percent. He calls the current economy “a sputtering recovery,” adding, “confidence is holding kind of steady; it’s not increasing as much as we thought it might.”

So for the Fed to hold off on a rate increase “would send a negative signal to the marketplace, and the same thing would happen if they raised rates by more than a quarter point.”

This line of reasoning defines the conventional wisdom, and it baffles Marc Schwaber, executive vice president of retail lending for MortgageIT. He thinks the Fed shouldn’t raise the federal funds rate because an increase would weaken the strongest sector of the economy: the housing market.

“The only thing that seems to be fueling our economy is the fact that our housing market is continuing to be strong,” Schwaber says. “I can’t imagine taking the legs out from under the one thing that’s fueling our economy.”

Indeed, home sales, construction and mortgages are going strong, and American consumers are driving the global economy by borrowing from their homes’ equity and buying imports. Of course, you expect a mortgage banker to object to anyone tampering with the golden goose of low interest rates, but Schwaber says he’s talking out of more than mere self-interest.

It looks like OPEC, the oil cartel, will cut production next year to keep prices between $33 and $38 a barrel, and there’s no inflation to tame, last month’s job growth was disappointing, and consumer confidence has declined four straight months, Schwaber says.

“A quarter of a percent is not tremendous harm, but why would you want to inflict any harm?” he says. “It’s not like everything is going in the right direction.”

The Fed’s decision is expected to be announced about 2:15 p.m. Eastern time Tuesday.