Hold Your Breath: Interest Rates Up

INTEREST rates will go up again in the United States next week. That's what many economists expect Federal Reserve policymakers to decide when they meet Monday and Tuesday in Washington.

The Fed, predicts consulting economist David Wyss, will push up the discount rate (the rate the Fed charges on loans to commercial banks) to 3.5 percent from 3 percent and the federal funds rate (the rate commercial banks pay on overnight loans to one another) to 4 percent from 3.75 percent.

Another consulting economist, Joel Prakken, says the Fed funds rate could be shoved up as much as 0.5 percent.

``It will be a surprise to just about everyone in the [economic forecasting] business if it didn't go up,'' says Mr. Prakken, a vice president with Laurence H. Meyer & Associates in St. Louis. Some on Wall Street were anticipating Fed action this week, particularly after the report a week ago that the unemployment rate had dipped to 6.4 percent last month, and nonfarm payrolls swelled by 267,000, considerably more than many analysts had expected.

For the consumer, the Fed's move will likely mean higher interest charges on mortgage, home equity, and auto loans. The prime rate that banks charge on their loans to low-risk customers has already moved up to 6.75 percent and could go higher. But the interest banks pay on deposits has barely risen. Banks make more money when the spread widens between their cost for money and the interest they pay on deposits.

By boosting rates, the Fed intends to slow the economy to a noninflationary rate of growth. Mr. Wyss says the short-term federal funds rate will be raised to 4.5 percent by late this year. Based on this assumption, his firm (DRI/McGraw-Hill, a consulting firm in Lexington, Mass.) predicts that real national output will grow at about a 3 percent rate for the remainder of the year. Because 1993 started so weak and ended so strong, the average level of output for all of 1994 will exceed the 1993 average by 3.6 percent in real terms. That would be the best growth year since the recovery started in March 1991.

Consumer prices will rise 2.8 percent this year, less than the 3 percent in 1993, DRI says. The predictions of Laurence H. Meyer, a competing firm, are almost identical - within 0.1 percent for both inflation and growth.

Both Wyss and Prakken agree with the Fed's decision to raise interest rates because of the need to preempt a rise in inflation.

``The economy is close to full employment by our measure of NAIRU (the nonaccelerating inflation rate of unemployment),'' notes the latest Laurence H. Meyer report. ``We place NAIRU at 6.3 percent, but we have to admit that there remains considerable uncertainty about this estimate.''

DRI puts NAIRU at 6.25 percent, which is also about where the Fed sees it. This means that, if the unemployment rate drops below that, inflation rises - if the estimate of NAIRU is correct.

Some economists say NAIRU is lower in the 1990s than in the 1980s because labor has less bargaining power, business is more cost-conscious, and global competition keeps the pressure on prices. If so, the Fed could let the economy run at its current good pace a little longer before putting on the brakes.

Prakken's firm says it can find no statistical evidence of this shift, though there may be ``some truth'' to it. Wyss says he sees two labor market trends that could be affecting NAIRU. One is that the average length of job tenure for many has dropped to around five to seven years. This increase in ``frictional unemployment,'' as these workers seek new jobs, would boost NAIRU. A second trend -

the apparent existence of a great deal of underemployment - would tend to decrease NAIRU.

What can be done to reduce NAIRU?

Wyss says unemployment benefits could be reduced or cut off sooner. The jobless could be required to work for their benefits - say, weeding parks. These measures would encourage the unemployed to take whatever jobs are available. Prakken suggests ending the minimum wage. Both talk of better information systems for matching the qualifications of the jobless with the needs of jobs. Both say they feel sorry for the unemployed.

``It is insane that we have highly educated people without a job,'' Wyss says.