The U.S. central bank, the Federal Reserve, will announce Wednesday the result of its latest deliberations on short-term interest rates. It is widely expected that the Fed, for the first time in four years, will lift rates from their current 40-year low.
The overnight fed funds rate, an interest rate controlled by the central bank, stands at one percent, its lowest level since 1958. Between 2000 and 2003 the central bank aggressively stimulated economic activity by reducing the fed funds rate 11 times, steadily bringing it down from six and a half percent.
Today's economic environment is quite different. Business activity is vibrant. Economic growth exceeds three and a half percent. And long dormant inflation is again on the rise. That's why analysts are convinced that the Federal Reserve will end the stimulus of cheap money and gradually bring monetary policy back to neutral.
Scott Brown, a money manager at Raymond James brokerage in St. Petersburg, Florida, tells Bloomberg News that he expects several rate increases over the next few months.
"Yes, I think several 25 basis point [1/4 percent] rises at each Federal Reserve policy-making meeting [roughly every six weeks] well into 2005 are likely," he said. "You know to get to a neutral fed funds rate [a rate just above the inflation rate] you have to get to three and a half to four percent. We're at one percent now. So if they're doing [only] 25 basis points per meeting, you're looking at a very lengthy process."
So, why should it matter if interest rates rise? The answer is that millions of Americans are in debt for everything from the home mortgages they are financing to automobiles and consumer goods. Much of that debt is at variable interest rates, meaning that as rates rise so do debt payments.
Experts say rising debt payments, when combined with already higher energy prices, could slow economic activity and depress consumer confidence. In addition some sectors of the economy, like home construction, are very sensitive to interest rates. Rising rates could end the boom in the housing market.
Todd Salamone, an analyst at Schaeffer Investments in Cincinnati, Ohio, tells Bloomberg News that the U.S. economy may not be as solid as some experts assume.
"Obviously there is a geopolitical risk out there [Iraq, terrorism]. There is an inflationary risk out there. And yet what we're concerned with is the complacency that we see in regard to those risks," he said. "It seems that whenever we're reading newspaper articles, what have you, Wall Street is taking the angle that everything is fine. But when you look at studies, when the Fed enters a process of rising interest rates, the stock market does under-perform relative to its norm."
The stock market, four years after the bursting of the high-tech bubble that had taken prices to record highs, fell precipitously in 2001 and 2002, rebounded in 2003. This year it has been steady.
What effect is an rate increase likely to have on the economy? Recent experience gives a mixed answer. In both 1994 and 2000 the Federal Reserve raised short-term interest rates several times. In 1994 and 95 the economy performed well. In 2001, however, it slipped into recession.