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Federal Reserve is at a turning point

By Drew DeSilver
Seattle Times business reporter

JOHN LOK / THE SEATTLE TIMES Monica Cary and her husband, Matthew, are glad that they got the money together now to buy their fixer-upper because interest rates are bound to rise.

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Cary, a 34-year-old law student at Seattle University, ticked off a list of economic and political factors — the federal deficit, high oil prices, Social Security, corporate malfeasance — and came to one conclusion: He's glad he and his wife, Monica, followed their instincts and bought their Central Seattle fixer-upper last month instead of waiting.

"If you're young and you even think you might want to buy a house — beg, borrow from your folks, do whatever you need to do, because money's not going to be this cheap a year from now," Cary said.

Across the nation, economists and bond traders, homebuilders and homebuyers are all making their best guess on where interest rates are headed.

And Tuesday and Wednesday, they'll be watching the Federal Reserve. Most expect that for the first time in four years, the central bank will raise its key short-term-rate target.

But those watching will also seek clues to what the Fed might do in the future: Will some shift in tone indicate the Fed's policy committee has become more concerned about inflation? That could portend steeper rate increases ahead. Or will the panel reaffirm that inflation isn't too worrisome, implying a gradual rise in rates?

Fed Chairman Alan Greenspan and his colleagues take a satellite's eye view of the economy. Through their influence on interest rates, they try to strike a balance between the benefits of the economy running at full steam and the risks of inflation surging out of control, as it did in the 1970s.

Federal Reserve facts Structure: The Federal Reserve System has two levels: • A seven-person Board of Governors, appointed by the president and confirmed by the Senate. Alan Greenspan is chairman of the board. • Twelve Federal Reserve banks. Each one serves as a bank for commercial banks in their region; member banks have to keep some of their reserves on deposit with their regional Federal Reserve Bank. The Federal Reserve Bank of San Francisco covers most of the Western states, including Washington; it has branches in Seattle, Portland, Los Angeles and Salt Lake City. Federal Open Market Committee: Responsible for monetary policy. The seven governors and the president of the Federal Reserve Bank of New York are permanent members; the heads of four other regional Federal Reserve Banks rotate on and off each year. (The seven nonvoting regional bank heads sit in on FOMC discussions.)

Indirectly, their decisions affect how much businesses invest in new plants and equipment, how many people are hired and whether those people can afford to buy a house or charge a new bedroom set on their credit cards.

"The 19 people sitting around the (committee) table don't think, 'If we keep rates low, car dealers can offer zero-percent financing,' " said Karma Hadjimichalakis, a senior lecturer in finance at the University of Washington Business School and former visiting economist at the Fed.

"The ultimate goal is the health of the economy, not interest rates," she said. Adjusting those rates "is just a means to an end."

Fed's financial juggling act

The Federal Reserve System, which marked its 90th birthday last December, is the nation's central bank.

As such, it has several jobs, ranging from the tedious but necessary (distributing currency, routing checks between banks) to the potentially crucial (acting as a backstop so the banking system won't collapse Great Depression-style).

But the Fed's main responsibility is to manage the U.S. money supply in line with three sometimes conflicting goals: low inflation, moderate long-term interest rates and maximum employment. The body charged with that juggling act is the Federal Open Market Committee; it's this committee that will meet Tuesday and Wednesday.

Interest rates — the price of borrowing money — are like oil on the machinery of the U.S. economy. Low rates encourage people and businesses to borrow and spend, which revs up the economy's production of goods, services and jobs but also increases the risk of inflation; high rates discourage borrowing and spending, which cools off the economy.

So if you want to smooth out the highs and lows of the economy, interest rates are a good tool to use.

			Follow the Fed ... If the Federal Reserve's Open Market Committee decides the economy is running too hot and might set off inflation, it will raise its target for the federal funds rate. Here's what happens next: · The Fed sells government securities into the open market. · When banks buy the securities, they pay by debiting their reserve accounts with the Fed. · With less money in reserve, banks can't lend money to other banks as easily. · As a result, the federal funds rate (the rate banks pay on overnight loans between each other) rises. Direct Effects Because interest rates tend to move together, other short-term rates (such as those on Treasury bills and commercial paper) rise fairly quickly. People seeking higher yields move cash from their bank accounts into short-term securities. That means banks have less money to lend to businesses and consumers. Businesses and consumers still want to borrow money. As they chase fewer dollars, interest rates rise. Some businesses and consumers will decide they can't afford the higher rates and refrain from spending. Indirect Effects Average 30-year mortgage rates Source: Freddie Mac, Weekly Mortgage Market Survey If the financial markets perceive the Fed's action as the start of a trend, they'll assume short-term rates will continue rising. This will push up long-term rates on things like home mortgages, corporate bonds and Treasury bonds. Higher long-term rates will reduce the demand for big-ticket items like cars and houses and make businesses less likely to spend on plants and equipment. Foreign-Exchange Effects As U.S. interest rates rise, foreigners will use their currencies to invest in dollar-denominated securities. As a result, the dollar becomes more expensive relative to other currencies. Imports are now cheaper, in dollar terms, than they were before. People will be more inclined to buy imported goods than American goods, and fewer American goods will be produced.

The Fed, however, doesn't set interest rates directly, though media reports sometimes conjure up the image of Greenspan as an all-powerful wizard.

When the Federal Open Market Committee meets, the only thing it does is set its target for the federal funds rate — an obscure rate that banks pay on overnight loans from other banks. It then buys and sells government securities in the open market in such a way that the rate hovers close to the target.

Raising that target rate, as the Fed is expected to do this week, does have a real impact on the economy, Hadjimichalakis said: It lowers the amount of cash banks have to lend out, thereby slowing the economy and raising longer-term interest rates.

Much of the Fed's power over the economy, however, derives from how businesses and financial markets respond to its interest-rate moves, and how they try to anticipate what it will do in the future.

Given the relatively strong economy, a quarter-percentage-point rise in the federal-funds target by itself probably won't affect the economy much, said Zachary Karabell, a senior economic analyst with Fred Alger Management in New York.

But the rate decision, combined with the Federal Open Market Committee's updated statement on its outlook for the economy, will signal the financial markets how steeply the Fed wants to see rates go up, he said.

It also will indicate how concerned the Fed is that inflation — at modest levels for most of the past two decades — might rise up again.

All those expectations, Hadjimichalakis said, are built into the rates that lenders charge borrowers. And even small rate changes can have a significant impact on pocketbooks — especially when the money markets try to get a jump on the Fed's next move.

Take the Carys again.

Because they closed on their house over Memorial Day weekend, they locked in a 6 percent rate over the 30-year term of their mortgage. That works out to principal and interest of about $1,380 a month.

However, long-term rates had begun rising in March, as it became clear the Fed was ready to start a new cycle of rate-tightening. Had the Carys bought their home in mid-March, before mortgage rates began climbing, they might have gotten 5 percent; that would have saved them $145 a month, or $1,740 a year.

If Cary's forecast is right and mortgage rates rise, say, a half-percentage point higher than they are now, a mortgage comparable to theirs would cost $1,454 a month — $888 more a year than they pay now.

Steering in a fog

As a regulator of the economy, the Fed has some advantages over Congress. While tax and budget bills take months to become law, the Fed can move swiftly: In 2001, after it became clear the United States was falling into recession, the Fed cut its target rate seven times between January and August; after the Sept. 11, 2001, attacks, the Fed cut four more times in an effort to pump money into the financial system.

But the Fed has some major limitations as well. It can take many months for each Fed action to work its way through the broader economy. Because of that lag, the Fed can easily find itself trying to cool off an economy that's already slowing down on its own. (Some Fed watchers say that's exactly what happened when the Fed raised its target a half-percentage point in May 2000, after the tech-stock bubble had begun deflating.)

And, the Fed doesn't know precisely how a specific interest-rate move will affect, say, the unemployment rate: In a speech last month in Seattle, Fed governor Ben Bernanke compared monetary policy to playing miniature golf without knowing whether each putt will send the ball two inches or two feet.

"One of the things I've learned as a policy-maker is how foggy the world is when you're trying to peer ahead," Bernanke said.

Partly for that reason, he said, the Fed tends to move in many small steps rather than a few big steps. Not only does such a "gradualist" approach make it easier for the markets to forecast future Fed moves, he said, but if the Fed later decides it's moving in the wrong direction, it's easier to reverse course.

Until recent months, the Fed's biggest concern was that the economy could fall into deflation — a crippling condition where prices fall throughout the economy and business investment grinds to a halt.

The last time the United States experienced deflation was during the Great Depression; to forestall anything like that recurring, the Fed last summer cut the federal funds target to 1 percent, its lowest level in more than four decades.

Now, with recovery well under way even in the Northwest, the financial markets probably will interpret even a small increase in the target rate as a signal that the Fed has begun a tightening cycle.

In anticipation of that, real-world interest rates began rising months ago.

Average rates on 30-year mortgages, for example, have risen from 5.38 percent in mid-March to 6.25 percent last week.

The yield on the 10-year Treasury bond, a benchmark for other long-term rates, has risen from 3.68 percent on March 16 to 4.65 percent last week.

In effect, Hadjimichalakis said, the markets have already done some of the Fed's work for it.

Or, as Bernanke quipped in his Seattle speech: "The punch bowl isn't gone, but it's halfway out the door."

Drew DeSilver: 206-464-3145 or ddesilver@seattletimes.com

Copyright © 2004 The Seattle Times Company

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