Rate hikes as a sign of financial pep

Wednesday, the Federal Reserve is expected to raise the cost of borrowing by a quarter of a point - without costing the economy much in terms of jobs or growth.

The Fed has already raised rates three times this year - a testament to an economy that has enough momentum to shrug off such moves. The fact that the central bank is poised to tap the brakes once again signals that the economy may have gotten past the soft patch it hit this summer when skyrocketing oil prices caused growth to slow.

Moreover, the Fed's program of raising rates - which may happen next month as well - has not disturbed Wall Street, which last week embarked on its sharpest rally since March 2003.

"The Fed has done a good job of telegraphing," says Sam Stovall, senior investment strategist at Standard & Poor's in New York. "What the Fed has been saying is, 'Here comes a left hook, you'd better duck,' and it's working."

Just last week, the Fed and the newly reelected president got some good news on the economy. The Labor Department reported October employment grew by a strong and surprising 337,000, far above the consensus estimate of 175,000 jobs. Some of the gains are related to rebuilding in the South after the four hurricanes in August and September. Some other jobs may have been connected to the election as both political parties added to people working their call centers, organizing rallies, and mailing out fliers.

For the most part, however, the job gains are the result of companies running out of ways to squeeze more work out of their existing labor pool, says William Dudley, chief economist at Goldman Sachs. "Productivity growth is slowing - it was up only 1.9 percent in the third quarter - so companies have to start hiring people."

Yet as the number of new jobs rose, so did the unemployment rate - to 5.5 percent, up 0.1 percent. Economists said this is related to more people reentering the workforce as they hear that new jobs are being created. "The labor pool increased by 500,000, which is a sign of optimism by people who think jobs are out there," says Robert MacIntosh, chief economist at Eaton Vance in Boston.

At the same time, the Fed is getting some help in fighting inflation as the price of oil has started to come back down. Last week, those prices fell by about $5 a barrel. In the past two weeks, the price of home heating oil dropped by almost 20 cents a gallon.

"I think it makes life easier for the Fed, which is trying to balance growth and inflation," says Mark Zandi of Economy.com. "When oil prices fall, it supports stronger growth and lower inflation."

But Mr. Zandi warns that energy prices remain a concern because they are still high compared with last year. "They could rise further because we are entering winter and inventories are still lean."

The Fed will also be keeping an eye on the trade deficit, which continues to grow. "The deficit is a problem if the Fed thinks it will undermine the value of the dollar and spark higher inflation," says Zandi. "But I think the value of the dollar plays a relatively small role in their thinking."

One exception, says Zandi, is if the dollar were to stumble compared to a large basket of currencies. "That might spark inflation and cause the Fed to tighten when they don't want to," he says, adding, "It's a possible scenario but not a likely one."

So far this year, the dollar has fallen in an orderly way.

Since 1994, the Fed has had two major programs of rate increases: from February 1994 to February 1995 and from June 1999 to May 2000. The more recent program resulted in six increases as Fed Chairman Alan Greenspan attacked what he called "irrational exuberance." The earlier Fed move included seven increases, as short-term rates went from 3 to 6 percent.

"The economy [in 1994-95] was very strong, and we were coming off a period of what were thought to be extraordinary low interest rates," says Paul Kasriel, an economist at Northern Trust Co. in Chicago. "The Fed was acting in a very responsible way by preempting a rise in inflation."

Whether the Fed will continue its interest-rate increases next year is still unclear. Economists, for one thing, have been lowering their estimate for growth in 2005.

"Household savings are low; there will be no more tax cuts; mortgage refinancing is not as much of a factor," enumerates Mr. Dudley for why he expects the economy to grow by a modest 3 percent next year.

With such expectations, some economists believe the Fed will hold off on any future rate hikes. "I think the Fed will take a six month pause," says Mr. Kasriel.

A pause also makes sense to Anthony Chan, an economist at JPMorgan Fleming Asset Management in Columbus, Ohio. Still, he expects the Fed will end up raising rates next year by 1 to 1.5 percentage points. "I think the Fed is determined," says Mr. Chan. "I don't doubt they will raise rates well into 2005 and may extend into 2006."