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The Fed and Interest Rates

Lee Price
Research Director, Economic Policy Institute
Wednesday, June 30, 2004; 3:00 PM

The Federal Reserve will announce their much anticipated decision on interest rates this Wednesday. What impact will the decision have on consumers? How will different kinds of debt, such as mortgages and credit cards, be affected by a rate hike? When will consumers feel the pinch if rates are increased?

Lee Price, research director at the Economic Policy Institute, will discuss these issues Wednesday, June 30 at 3 ET following the Fed decision.


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Lee Price: As everyone had predicted, the Federal Reserve's Open Market Committee (FOMC) just raised their "federal funds" rate from 1.00 to 1.25 percent. The only news was the language in the statement issued with their announcement of the rate hike. The key sentence in the FOMC statement said that "with underlying inflation still expected to be relatively low, the pace of upcoming rate hikes would be measured."

The statement did a balancing act in its discussion of inflation. In addition to the sentence above, the statement also noted that a portion of the recent uptick in inflation uptick "appears to have been due to transitory factors." To appease those more concerned with inflation, the statement concluded that the FOMC will respond as necessary "to fulfill its obligation to maintain price stability."

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Washington, D.C.: What are you expecting the Fed to do down the road? Increase rates at a faster pace or raise by a quarter-point? What level do they want to get the prime rate to?

Lee Price: For some time, the prime rate has moved in lock step with the Fed funds rate. If you have a loan keyed to the prime rate, expect your rate to go up a quarter point.

In an analogous situation ten years ago, the Fed began raising rates after years of lowering rates, because of recession and slow growth. In a year's time it raised rates from 3.00% to 6.00%. Growth slowed from 4-1/2% in the first half of 1994 to less than 1% in the first half of 1995.

They appear to have learned their lesson. The "measured" language suggests that (unlike 1994) they will stick to 1/4 point increases and only move during their 8 meetings a year. A lot depends on incoming data on growth, jobs, and inflation. Growth seems to be cooling down a bit. My hunch is that rates will be 2-1/2% in a year.

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Washington, D.C.: Like many consumers, the federal government has been financing (and refinancing) debt with the low interest rates over the past few years. Were these higher rates used for budget and debt projections over the next few years?

Lee Price: In making budget projections, both the Administration and the Congressional Budget Office have assumed that interest rates would rise in the next two years.

By the way, the decline in rates has caused interest payments to decline in recent years despite the run-up in debt. There will be a significant increase in interest payments in the years ahead, because of higher debt and higher rates.

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Vienna, Va.: Is it certain that the Fed will increase rates again in August? Considering all the conflicting data we've been getting of late (the decrease in 1Q GDP, today's unexpected drop in Midwest manufacturing, etc), is it possible the Fed may stay at 1.25 in August?

Lee Price: No, it is not certain. But the new data on growth and jobs would have to be pretty weak and the new inflation numbers pretty low for them not to raise rates again in August. They believe that 1.25% is too low for very long. They probably do not want to wait until November to get to 1.50%, but they also do not want to draw attention to themselves during the prime election season of September or October.

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Denver, Colo.: Will this increase have a positive impact on interest earned on things like lawyer trust accounts or personal savings accounts any time soon?

Lee Price: It should have some impact, but the effects tend to be less immediate than the banks' lending rates.

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Kalispell, Montana: What impact do you predict for mortgage interest rates?

Lee Price: Longer term rates have gone down today, but they are also higher than they were several months ago. That suggests that the Fed has done a good job of signalling its intentions -- and of assuring people that the prospects for inflation will not require large rate hikes in the months to come.

In 19994-95, long term rates initially rose almost as much as short term rates. In that episode, the Fed surprised the markets with the aggressiveness of its rate hikes and caused many market participants to fear that the Fed knew more about inflation risks than they did.

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Washington, D.C.: What kinds of loans are keyed to the prime rate?

Lee Price: Many borrowers -- especially on small businesses and home equity -- have loans that are "prime plus." Depending on the credit risk, the loan may be a quarter point or three points above prime. The monthly interest on these loans will fluctuate with some posted prime rate -- say from a major bank or that posted in a specific daily paper.

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washingtonpost.com: Fed Raises Key Interest Rate by Quarter-Point (Post, June 30)

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Washington, D.C.: If the rate had been 2.00 and it was raised .25, then that would have been a 12.5% increase in the cost of funds. With the rate at 1.00, an increase of .25 is a 25% hike. Why do they make larger changes as the rate decreases and smaller changes as the rate increases? Thanks.

Lee Price: Most analysis of interest rates focuses on the point difference, not the percentage difference. Financial markets are driven by margins between borrowers and lenders. Private savers worry about inflation and should subtract that from the nominal return.

The Fed tends to move in multiples of .25, but when rates get higher, they are more likely to make moves larger than .25.

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Goldsboro, N.C.: Why do China and Japan continue to invest in U.S. bonds when they could obtain higher interest rates and appreciation of currency on euro bonds? How big is the U.S. bond market? What does it take to move the bond market?

Lee Price: Your question highlights the fact that China and Japan are not buying dollar assets as financial investments. In the first quarter of 2004, the U.S. had such a large trade deficit that it had to borrow at an annual rate of $550 billion. As private lenders shied away from lending to the U.S., Asian governments stepped in to lend at a $500 billion rate. They did so because they do not want the value of the dollar to go down. A lower dollar would hurt Chinese and Japanese exports into the U.S. market and favor U.S. exports competing in world markets. They are prepared to accept the financial losses (both short term and long term) to maintain the trade gains.

Total U.S. debt exceeds $4 trillion. Not all are bonds. Some are shorter maturities. The private bond market is even larger.

The bond market is moved when perceptions change about future short term rates. Bond rates go down when the economy slows down or inflation slows -- the Fed lowers rates when those two things happen. When the economy strengthens or inflation heats up, bond rates fall.

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Quito, Ecuador: Can you please explain the disconnect between the 'low underlying inflation' and the bald fact that everything seems to be much more expensive?
Does it have anything to do with the recent change in calculating the PPI? And, while you're in the answering mood, exactly what was that change?
Thanks

Lee Price: In the last year, the prices of oil and other commodities have risen sharply. That feeds through into overall inflation. The Fed assumes that commodity prices will not continue to increase at the rate of the last year. If so, average inflation should go down. Prices will go up, mind you, but the rate of increase -- inflation -- will go down.

Part of the Fed's confidence comes from the fact that labor costs represent more than 60% of total costs. After adjusting for productivity, the cost of labor per unit of output has been near zero.

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Columbus Ohio: What immediate impact will this rate hike
have on the dollar exchange rate overseas?
Thank you.

Lee Price: My hunch is that today's announcement will have little effect on exchange rates. Like the long term rates, they have already adjusted. Anticipating higher U.S. rates, the dollar has already risen somewhat. Today's announcement was fully "discounted."

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Washington D.C.: Greetings Lee: My husband and I are getting take out a student loan which is on a variable rate. Up until now, we have been paying my daughter's $40K tuition from savings and out of pocket (monthly). Should we reconsider this decision due to the rise in interest rates?

Lee Price: It depends on the rate you would have to pay versus the rate you would get on keeping you money in savings and whether you think the two would move up together. Today's announcement should lead to higher returns for savers, so it does not mean that you should not take out loans at a favorable rate.

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Upper Marlboro, Md.: If interest rates go up, are home prices expected to go down?

Lee Price: If short term rates go up by 2 or 3% in the next year, it will have a major effect on long term rates, including mortgage rates. I do not predict that, in part because our economy has become quite attached to low mortgage rates. We are borrowing heavily against home equity. A sharp increase in mortgage rates would dampen the demand for homes. Some worry about a housing "bubble." A gradual increase in rates would cause home prices to flatten, but not to fall.

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Lee Price: You have asked many stimulating questions. I'm sorry that I could not get to all your questions. The question is not the effect of one .25% increase but how many more increases we will see in the next year. Let's hope that the Fed's 'measured' increases allow strong growth in output and jobs.

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