Fed at crossroads with interest rate policy

Jeannine Aversa

Tuesday, March 19, 2002 | 9:45 a.m.

WASHINGTON -- As the country bounces back from a recession, the Federal Reserve's next mission will be to prepare Americans enjoying the lowest interest rates seen in a generation for the possibility that rates will go higher this year, economists said.

The Fed's 11 interest rate cuts last year may have rescued the economy from the downturn that began in last March and will allow healthy economic growth to return in the months ahead, economists predicted.

Recent economic data suggest the recovery is gaining momentum. The nation's manufacturing sector, which lost hundreds of thousands of jobs during the recession as factories throttled back production, is mounting a comeback.

Also, companies that had been shedding workers to cope with the downturn added jobs in February for the first time in seven months and helped push the unemployment rate down to 5.5 percent, the lowest jobless rate since October.

Against this backdrop of improving economic conditions, economists believe the Fed will begin acting to shift its policy stance. Currently, the Fed's policy directive, which can signal future rate moves, is tilted toward risks of economic weakness, something that leaves the door open to interest rate cuts.

However, many economists predict Federal Reserve Chairman Alan Greenspan and his colleagues will change the policy bias at their meeting today. Economists are predicting the Fed will move to a neutral policy directive, which would mean they believe risks to the economy are balanced equally between economic weakness and the threat of inflation.

Economists view that as the first step toward preparing consumers and businesses for the possibility that interest rates may go up later this year.

"They are teeing it up for a rate hike," said Richard Yamarone, economist with Argus Research Corp. "They don't want to keep rates at a 40-year low for too long, because then inflation could blossom."

The Fed's chief policy-making group, the Federal Open Market Committee, started its meeting this morning and was to announce its decision in the afternoon. Most economists are predicting the Fed also will decide to leave interest rates unchanged, as it did at its last meeting in January.

The Fed's last rate cut came on Dec. 11 and left the federal funds rate, the interest that banks charge each other, at a 40-year low of 1.75 percent. Commercial banks' prime lending rate was reduced in lockstep with the Fed's 11 rate cuts and now stands at 4.75 percent, a level last seen in November 1965.

"It is clear we are no longer in a time of economic crisis, but we have a crisis-level borrowing rate at the moment," said Carl Tannenbaum, chief economist at LaSalle Bank/ABN AMRO. "The first step is to go to neutral and then start reeling in a lot of the slack."

Economists believe Fed policy-makers will begin raising rates either at their May 7 or their June 25-26 meetings. That would mark the first rate increase in two years. Some are forecasting the federal funds rate will rise to around 3 percent and the prime to around 6 percent by the end of this year. Such rates still would allow the economy to grow and would remain favorable to many borrowers, analysts said.