Why interest rates may rise further

The Federal Reserve has never raised interest rates 15 consecutive times. But Tuesday, the nation's central bank is expected to hike rates another quarter percentage point - yes, the 15th increase.

If the Fed raises rates, it will move the short-term cost of borrowing money to the highest level since March 2001, just when the economy moved into a recession. However, this time, the Fed is acting at a time when the economy - except for housing - is motoring along at a fairly brisk pace. It is because the economy is so strong that analysts believe Ben Bernanke - who is chairing his first Fed meeting Tuesday - will feel comfortable with continuing the policy of increasing rates by a quarter percentage point.

In fact, such increases will continue at least through the May 10 meeting, economists believe. It's part of an ongoing policy of "monetary gradualism," the equivalent of adding only a few grains of salt at a time to see how something tastes.

"[Mr. Bernanke] has said that raising interest rates gradually is a reasonably good strategy that minimizes the mistake of overshooting," says Anthony Chan, chief economist at JPMorgan Private Client Services in Columbus, Ohio.

The Fed started raising interest rates on June 29, 2004, when short-term rates were 1 percent. By the end of the day Tuesday, the Fed funds rate - the cost to a bank of borrowing money overnight - could increase to 4.75 percent. As this rate rises, consumers who have short-term loans, such as auto loans and credit-card balances, could see their interest costs rise.

Until now, the Fed's rate increases have had minimal effect on the economy, says J. Michael Barron, CEO of Knott Capital, which manages funds in Exton, Pa. "But we feel that will start to change and the economy will start to slow significantly."

One of the first signs of a weakening economy came on Friday, when the Commerce Department reported that February sales of new homes fell 10.5 percent, the steepest drop in nine years. Inventories of unsold homes rose to a record 548,000 units. The rising inventories helped put pressure on median prices, which dropped 1.6 percent from January to $230,400.

However, the housing picture is not totally negative. Last Thursday, the National Association of Realtors reported that the sales of existing homes rose by 5.2 percent, after dropping for the prior five months.

The future direction of the housing market is likely to be one of the special topics discussed at the Fed meeting - which was stretched to two days (Monday and Tuesday) at the request of Bernanke, says Lyle Gramley, a former Fed governor.

Mr. Gramley, now a consulting economist at Schwab Washington Research Group, says the Mortgage Bankers Association's weekly application index is now at its lowest level of the year, yet another indication of the sector waning. "If housing weakens, home prices do too, and that could have a big effect on consumer spending," Gramley says.

The strong housing market has added about 0.4 percent to the nation's gross domestic product, economists say. But the actual impact has been even larger since many homeowners have taken out home-equity loans and spent the money on vacations, new cars, kitchen remodelings, and college educations for their children.

Consumers withdrew $600 billion in home equity in 2004 and $700 billion in 2005, according to an analysis by Gina Martin, an economist at Wachovia Bank in Charlotte, N.C. Last year alone, this added about 8 percent to consumer income.

"We expect interest rates to continue rising and home prices to rise at a slower pace in the year ahead," writes Ms. Martin in a report. "This combination makes withdrawal of mortgage equity a less likely source of funds for consumers in the future."

If housing continues to slow, the ripple effect will be seen in the nation's GDP numbers later this year. "If housing goes from a positive to a negative, it may subtract up to 0.5 percent from the GDP," says Scott Brown, chief economist at Raymond James & Associates in St. Petersburg, Fla. "Instead of a 3.5 percent increase in the GDP in the second half, it's more likely to be 3 percent."

Offsetting the slowing housing market, however, is a strong jobs market. This is likely to be another area of discussion for the Fed, says Gramley. "They will be asking, 'How close we are to full employment?' " he says. "The anecdotes in the Fed's Beige Book [a report of economic activity done eight times a year in Fed districts] found some shortages of labor in construction, trucking, even financial services. It's enough to make you think we're close to full employment."

The March employment report will be issued April 7. "This report will be watched closely since at least one of the Fed presidents, Janet Yellen [Federal Reserve Bank of San Francisco], has said that if there were a further substantial decline in unemployment, it will set off alarm bells in her head," Gramley says.

The Fed will also be watching upcoming retail sales. Easter falls on April 16, later than usual. "This means we may end up with a softer March but much stronger April," says Mr. Brown. "Easter is one of the biggest retail seasons. It's when new merchandise comes out and families get together for dinner. The later in the year it falls, the bigger the boost to the economy, since the weather is more likely to be favorable."