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Fri, Mar 22, 2002 - Page 21 News List

US Fed facing a dilemma as it mulls rate hikes

HOW HIGH? Analysts say borrowing costs in the US could rise to 3 percent by year end, up from today's low rate of 1.75 percent


Now the US Federal Reserve has put financial markets on notice that it may raise interest rates, it faces the delicate task of deciding where it wants US borrowing costs to go and how quickly to take them there.

Analysts said the Fed will aim for a "neutral" level of interest rates that will neither push too hard on the economic gas pedal nor hit the brakes on the fledgling expansion.

Wherever that ideal level of interest rates may lie, most private economists feel certain it is definitely above the current 1.75 percent, a 40-year low for the key federal funds rate that influences other lending rates.

"The 1.75 percent rate just sticks out like a sore thumb. You look at it and you wonder, `Why is it there?'" said Chris Rupkey, economist at Bank of Tokyo/Mitsubishi in New York.

But Rupkey noted that opinions range about where the Fed needs to take the rate, with some economists eyeing the 2.75 percent to 3 percent area and others suggesting borrowing costs eventually may need to climb as high as 4.5 percent.

Economists said the 1.75 percent rate seemed appropriate a few months ago when prospects appeared more dicey for the economy, which was facing the double-whammy of a business-led downturn and the blow to confidence from the Sept. 11 attacks.

But with the economy now cruising along at an annual rate that some estimate could be close to 5 percent, the rate seems too low and the Fed itself has described its policy stance as "accommodative."

The US Federal Reserve on Tuesday left interest rates untouched but issued a statement abandoning its 15-month-old warning that excessive weakness was the main economic threat. It instead adopted a more balanced position that views excessive economic weakness and overheating as roughly equal risks.

The Fed went further to state the economy was "expanding at a significant pace," although it said there were still some uncertainties about how well spending demand would hold up in the coming months.

The shift in language does not commit the Fed to boosting rates but economists said it was a necessary first step to psychologically prepare financial markets for such a move.

Markets sold off sharply on Wednesday as investors digested the rhetorical shift and braced for higher rates ahead. Many believe that barring a dramatic setback for the economy over the next few months, higher rates are inevitable.

A poll by Reuters taken following the Fed meeting showed that all 24 of the major government bond dealers think policymakers will keep interest rates steady at the next meeting on May 7. But a majority -- 14 of the 24 -- expect a rate increase at the June 25-26 meeting.

The poll did not suggest analysts expect a very aggressive rate-rising campaign. Many of the firms were eyeing the 2.25 percent to 2.75 percent region, with some viewing 3 percent as a likely area for rates to end the year. Even a 3 percent fed funds rate at the end of this year would constitute a far more gradual pace of rate moves than last year, when the Fed hacked 4.75 percentage points off overnight rates.

James Glassman, economist at J.P. Morgan in New York, said while the Fed will eventually want to get to a neutral level of interest rates that is neither too loose nor too restrictive, there is no urgency to do so quickly because inflation is low. "The pattern that we've seen with the Fed, because of this low inflation, is that they've been tended to be cautious about moving rates up, but as we saw last year they can be quick to respond when there is an [economic] downturn," Glassman said.

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