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Rate Hike Fears May Be Overblown

As the Fed prepares to tighten credit costs, some say the economic effect will be minimal.

June 28, 2004|Tom Petruno and Kathy M. Kristof | Times Staff Writers

The cheapest money in 46 years soon will be history, if the Federal Reserve acts as expected this week and boosts interest rates.

Some economists are raising red flags: Higher rates can slow business investment, depress consumer spending and make heavy debt loads more onerous. The housing market, particularly in California, is seen as vulnerable because some people who bought using low-interest, adjustable loans may have trouble making payments as rates rise, leading to foreclosures.

Erin Grotz, however, doesn't see much reason to be concerned. She figures that the lowest credit costs in a generation will help her for years to come.

The 26-year-old Atlanta resident recently graduated from law school with $60,000 in student loans. She and her husband also have two car loans and a mortgage. Their total debt is twice their annual income.

But like many consumers, Grotz has locked in low, fixed rates on her home and her student loans, and she and her husband have zero-percent loans on their cars. "It was just good timing -- because of what was going on in the economy, we got really good rates," she said.

As the Fed prepares to raise its key short-term interest rate from the current 1%, weaning the nation from the super-cheap credit of the last few years, much of the focus has been on the risks the economy faces as money gets more expensive.

But some analysts say the concern may be overblown, obscuring the benefits millions of consumers and businesses will continue to enjoy from the long period of rock-bottom rates.

"I don't think it's going to be a big deal" for many or most Americans as rates go up, said Joel Prakken, chairman of economic consulting firm Macroeconomic Advisers in St. Louis.

Business groups also are downplaying the effect. "A modest increase in interest rates is not going to hinder investment and expansion," said David Heuther, an economist at the National Assn. of Manufacturers in Washington.

For Fed policymakers, who are expected to raise their benchmark rate from 1% to 1.25% at a meeting Wednesday, the shift would affirm that the economy is on solid footing.

The Fed's rate, the so-called federal funds rate, is what banks charge one another for overnight loans. Other rates, such as banks' prime lending rate, are pegged to the Fed's benchmark.

The central bank steadily cut its rate from 6.5% in 2000 to 1% by last June to prop up an economy hit by tumbling stock prices, the 2001 terrorist attacks, corporate scandals and the Iraq war.

Among economists, there has been much debate over whether the Fed left money too cheap for too long. But the policy eventually had the desired effect: It fueled spending, bolstered Wall Street and powered the biggest U.S. growth spurt in 20 years.

Against that backdrop, Fed officials have warned since April that it was time to begin raising short-term rates. Long-term rates, such as on mortgages, already have jumped in anticipation of a Fed turnabout.

Because consumer spending is the primary driving force of the economy, a crucial question has been whether higher borrowing costs could suddenly sap Americans' desire or ability to spend.

One concern has been that spending was underpinned in recent years by the mortgage refinancing wave. Americans took advantage of lower interest rates not only to cut their monthly payments but also to pull equity out of their homes to pay for big-ticket expenses like cars.

Yet consumer spending has held up even as refinancing activity has dived since mid-2003 amid rising mortgage rates.

The optimistic view is that, as the expanding economy adds jobs and improves the outlook for workers in general, rising incomes will more than compensate for a lack of new mortgage refi savings, higher interest rates and higher debt levels.

"The time to worry about debt isn't when employment and incomes are accelerating," said Susan Sterne, president of Economic Analysis Associates in Greenwich, Conn.

What's more, the Fed has pledged to go slow in tightening credit. Many analysts expect short-term rates to rise a quarter-point every six to eight weeks into 2005. A measured pace of increases could lift the Fed's key rate to about 3% a year from now. That still would be far below the 2000 peak of 6.5%.

"I think they could go to 3% without a major negative impact on the economy," said Brian Wesbury, an economist at investment firm Griffin Kubik Stephens & Thompson in Chicago.

Some outstanding loans are certain to cost consumers more, including adjustable-rate mortgages, many credit cards and home equity credit lines. Even so, much of this debt will be insulated from rate hikes for months or years because of the terms of the loans, experts say.

Adjustable-rate mortgages, or ARMs, have become more popular, accounting for nearly a third of all new mortgages written. But of the $7.3 trillion in outstanding mortgage debt, ARMs make up only about 10%, according to mortgage finance giant Freddie Mac in McLean, Va. The rest is fixed-rate debt.

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