How rates shift, and then affect you

BY JAMES TOEDTMAN | CHIEF ECONOMIC CORRESPONDENT

June 29, 2004

If, as expected, the Federal Reserve raises interest rates this week, that means Chairman Alan Greenspan and the central bank's Open Market Committee agreed that the economy is growing fast enough to return the rates to more normal levels. Inflation is the particular concern. Though not increasing at an alarming pace, the central bankers would have to feel they could dampen the pressure by raising interest rates. That would have the effect of increasing the cost of borrowing money, which in turn would make individuals and businesses less inclined to spend. The committee decision would set a target rate of interest for funds loaned by the Federal Reserve. Technically, that rate hike is accomplished by taking money out of circulation, selling U.S. Treasury notes in exchange for cash reserves, which are then withdrawn.

What it really would mean is that car loans, home mortgages and business debt will become more expensive and may slow down the economy.

The Process

Making the Call

In Washington, Chairman Alan Greenspan convenes a meeting of the Federal Reserve Open Market Committee every six weeks. Greenspan, the six Fed governors and presidents of the Fed's 12 regional banks spend the morning discussing the condition of the economy. They discuss a regional analysis by economists at each of the 12 regional banks. They also discuss two volumes prepared by economists at the central bank: the Green Book analysis of national economic trends and the Blue Book of monetary policy options.

The Open Market Committee is a small group consisting of Greenspan, six Fed governors and Timothy Geithner, president of the New York Federal Reserve Bank, and four of the other regional bank presidents. The Fed's concern is employment and inflation, and the governors try to influence the economy so that new jobs are being created without firing up higher inflation.

The Fed's primary tool is something called the federal funds rate, the interest banks charge each other for overnight loans. The Fed acts by setting targets for that rate then selling or buying enough U.S. Treasury notes and bonds to achieve the final target. The federal funds rate is a very efficient tool.

After the late 1970s, when oil prices quadrupled, unleashing annual inflation as high as 14.8 percent, the Fed hiked its federal funds rate to 20 percent. By the end of 1982, inflation had dropped to 3.8 percent (although unemployment rose to 9.7 percent).

Conversely, after the Sept. 11, 2001, terrorist attacks brought the national economy to a standstill, the federal funds rate was cut six times to one percent, its lowest level in 46 years.

When the governors meet this week, they will analyze jobs, consumer confidence, retail sales, industrial production, wage and productivity trends and home building, they will see that the economy is growing.

Shortly after noon tomorrow, Greenspan will canvass the bankers for their consensus. It is now generally accepted that the committee will raise the Federal Funds rate by at least one-quarter of one percent

Tightening Supply

Responsibility moves to the New York Federal Reserve Bank in lower Manhattan and its Open Market Desk.

In the nation's complex money machine, Open Market Desk manager Dino Kos, who is also executive vice president of the New York Fed's market group, and staff analysts are the tinkerers/ worker bees/ grease. Each day, they oversee the nation's money supply, making necessary adjustments in case there is too much or too little in circulation. Their allies are 23 commercial and investment banks designated as the New York Fed's primary dealers, who implement the Fed's decision to buy or sell U.S. government securities as it tries to add or drain money from the system.

The Fed relies on the traditional economic forces of supply and demand. A decision to raise interest rates means that the cash in circulation must be reduced. That is accomplished by selling U.S. government securities - treasury notes and bonds - for cash, which is withdrawn from circulation. Approximately $150 billion a day is traded on the treasury market, and the Open Market Committee market analysts have calculated exactly how much cash must be withdrawn from circulation to achieve the rate hike.

Your Bank Reacts

Through a process that is part mechanical and part psychological, banks then adjust the interest rates charged for home mortgages, business loans, credit card fees and car loans.

In 1994, the federal funds rate target was raised from 3 percent and by Feb. 1, 1995, was 6 percent. The prime rate charged by large banks to their major customers rose from 6 percent in 1993 to 8.8 percent in 1995. Conventional, 30-year mortgage rates rose from 7.2 to 7.9, and rates for four-year car loans rose from 8.1 to 9.6 percent.

By one estimate, the Fed rate hike cost consumers between $547 and $755 in 1995 per household, according to the Financial Markets Center, a research center that studies the Fed.

For the past four years, interest rates have been the lowest in a generation. Mortgage rates dropped below 5 percent, business loan rates were at record lows, and dealers offered zero-percent financing for new cars. That era seems to be about to close.