If the Federal Reserve, as expected, raises short-term interest rates by a quarter of a percentage point tomorrow, many consumers, homeowners and smaller businesses will shortly be paying more when they borrow -- but not much more.
Banks likely will boost their 7.75 percent prime lending rates by the same quarter-point. Tied to the prime are rates for many home-equity loans, credit-card balances and small-business loans.
"I think you would see an industrywide increase of a quarter-point by the end of the week," said Wayne Ayers, chief economist at BankBoston. "The Fed would expect that and want to see it as well."
But even on a $20,000 loan, that would be only an added $50 in interest over the course of a year, some or all of which may be tax-deductible.
In terms of impact on the booming U.S. economy, however, that $50 would be just the tiniest tip of a very big iceberg.
First of all, millions of borrowers will be affected. More important, it's not just short-term rates that are influenced by Fed actions. In fact, longer-term rates determined by market forces -- as opposed to Fed edict -- have already risen sharply this year, partly because the economy is so strong that the demand for credit has shot up, and partly because of expectations that the Fed will act to rein in economic growth to keep inflation low.
In addition, many analysts expect that rising interest rates may put a lid on soaring stock prices, one of the driving forces behind the strong economic expansion in recent years.
"The swift rise in market interest rates now well in train is likely to provide an important assist in dampening demand in interest-sensitive sectors" such as housing, and in business investment, said economist Robert V. DiClemente at Salomon Smith Barney in New York.
"But more importantly, rising rates could serve as a cautioning device for overly optimistic consumers and businesses," DiClemente said. "In this context, policy action that locks in place a healthy sense of risk in financial markets could be ideal."
Recent Salomon research concluded that "the economy is sensitive to sharp changes in rates," he said.
For instance, a half-percentage-point rise in 10-year U.S. Treasury note yields, with other rates changing as they normally would along with such an increase, "would subtract about 0.4 percentage point from [economic] growth over the succeeding four quarters," DiClemente said. "By this estimate, the 1.3-percentage-point rise in yields since the beginning of the year likely will subtract 1 percentage point [from growth] by early next year."
One example of that impact: The rise in yields on those notes has led directly to a significant increase in rates on 30-year fixed-rate mortgages -- which, of course, increases a buyer's monthly mortgage payment. That has happened because most of the nation's mortgage money is provided indirectly by investors purchasing securities issued by housing finance lenders, which are an alternative investment to Treasury securities.
For any borrower, an increased interest bill means there is less money available for some other purpose. On the other hand, investors with money to lend may see their incomes rising, though not in many cases.
Ayers of BankBoston said many larger financial institutions acquire money to lend in what he called the "wholesale" money market, often by issuing certificates of deposit in denominations of $100,000 or more. Banks are paying much higher rates on such large CDs -- those yields are up about 0.4 percentage points since the middle of last month -- than they are on a typical small consumer CD like those being offered yesterday by Riggs Bank, which pays 3.15 percent for a three-month maturity.
"Most banks have not been competing aggressively for small deposits," Ayers said. "And there's certainly nothing automatic, that's for sure," about raising rates on small CDs if the Fed acts this week.
What the banks have been competing hard for are loans to large, creditworthy institutions, where the spreads between what the institutions have to pay to acquire the money to lend and what they charge borrowers has been razor thin. On the other hand, as their cost of funds goes up, as it has in recent weeks, they probably will pass most of that added cost on to the big borrowers.
Meanwhile, the firms that are big enough to raise money directly by issuing bonds and notes have been taking their lumps. The rapid run-up in longer-term rates has caused some companies to pull back planned issues and others to reduce the amount borrowed.
For example, Ford Credit Corp., the financing arm of Ford Motor Co., at least temporarily pulled back a multibillion-dollar issue. Another company, and one with a less stellar credit rating, car-rental company Avis Inc., last week cut a planned offering of 10-year notes by $50 million, to $500 million, and still had to pay 11 percent to attract investors, a half-percentage point or more than expected.
Until rates began to shoot upward, corporate borrowing ran at record levels for several months as a result of "the enormous capital requirements of business for merger activity and technology spending," DiClemente noted.
With higher rates, some of those mergers might not occur, some of that investment might not get made, and if that happens, it would be one more reason economic growth should slow a bit, which is the Fed's goal.
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