Wall Street braces for a Fed rate hike

It's been over two years since the Federal Reserve Board raised interest rates. Now, economists believe the Fed is close to making money more expensive once again.

Wall Street economists are now resigned to a 1/4-point rise in interest rates when the Fed meets for its monthly meeting at the end of June. But some are concerned that the move - if it happens - could be just the start of a series of interest-rate increases designed to nip inflation in the bud.

"Future rate hikes would be a signal to the markets that the Fed is concerned about staying ahead of the inflation curve," says Paul Kasriel, an economist with Northern Trust Company in Chicago.

The prospect of higher interest rates helped unsettle the financial markets last week. The interest rate on the government's 30-year bond hit a two-year high as investors anticipated the Fed move. As interest rates rose, the stock market fell.

The fears about inflation reflected in the rising rates and falling markets were renewed last week with news reports that the Japanese economy grew at an almost 8 percent annual rate during the first three months of the year. Although many economists were skeptical about the sudden turnaround, there was also news that the German economy, too, has started to show some signs of life.

"With the pickup in global economic activity you start to see an increase in demand for commodities, and we are in fact seeing industrial commodity prices moving up," says Mr. Kasriel.

With the Fed watching the inflation numbers closely, the markets are anticipating the release of the May Consumer Price Index (CPI) on Wednesday. The CPI, which tracks changes in the prices of consumer goods, rose 0.4 percent in April.

Merrill Lynch chief economist Bruce Steinberg says the May report will be "decisive" in determining whether the Fed raises rates. A Merrill Lynch computer model of how the Fed will act predicts that any CPI increase over 0.2 percent will prompt a rate rise. At the moment, Merrill Lynch is predicting a 0.1 percent rise in the core inflation rate, which excludes food and energy prices because they tend to have more short-term vacillation.

Even if the inflation rate comes in at a low level, it may take several months of low inflation to boost confidence in the bond market, says William Sullivan, an economist with Morgan Stanley Dean Witter in New York.

On Friday, the government reported the May Producer Price Index (PPI), a measure of costs for manufacturers, rose by 0.2 percent. The core PPI, excluding food, energy, and tobacco, was up only 0.1 percent. "The PPI number will have no influence on the Fed," says Sullivan. The Fed is focused more on the CPI as a measure of inflation.

The rise in interest rates in the bond market has already spilled over to the mortgage markets. Last week, long-term fixed-rate mortgages were going for more than 7.6 percent, compared with less than 7 percent several months ago. Despite the rate rise, the Mortgage Bankers Association reports that demand for loans rose last week as buyers sought to pin down rates before they go up any further.

That's the experience at Portsmouth, Va.-based Towne Bank, where demand remains strong, says Robert Aston Jr., the chairman and chief executive officer. "From a historical standpoint, rates still look attractive," says Mr. Aston.

When the Fed met last month, it warned it had a bias toward raising rates. It has sometimes said it was "tilting" toward raising or lowering rates without actually doing so. But this time, it might feel more compelled, says economist Lyle Gramley, a consulting economist at the Mortgage Bankers Association in Washington.

"The economy is growing too fast for too long," says Mr. Gramley, a former Federal Reserve governor. He argues that a rate rise will help slow the economy and take some fizz out of the stock market. "The Fed does not need to hit the economy over the head with a hammer," he says, "but if it can get the economy to grow at 3 percent instead of 4 percent, it would help."

If the Fed raises rates, Kasriel agrees it will quickly deflate the stock prices.

"One of the reasons for the market's high level is benign interest rates," says Kasriel. If the market starts to fall for several months, he conjectures, "this could ... lead to a significant retrenchment in consumer spending."

There's lots of anecdotal evidence that the stock market is becoming a significant factor in the economy. Every weekday morning at 5:20, Dean Witter's Sullivan stops at a diner in New Jersey for his morning tea. Since he is occasionally on television, it's not unusual for him to get questions. "Some truck driver will say, 'Hey , what about AOL [America Online] - I'm heavy into AOL," Sullivan recounts.

Gramley says there are stories about people now paying for stock purchases with their credit cards. "That is really scary," he says. But if interest rates rise, it will make those credit-card purchases more expensive and discourage speculation - one of the Fed's reasons to raise interest rates in the first place.