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Fed Makes Money More Expensive, Fails to Slow Economy
May 10, 2006

May 10 (Bloomberg) -- The Federal Reserve's nearly two-year campaign to make money more expensive has finally begun to succeed. What it hasn't done yet is slow the economy enough to ensure that inflation will remain in check.

The central bank's 15 interest-rate increases since June 2004, with a 16th expected today, have pushed mortgage rates to a four-year high and raised average rates on home-equity credit lines, credit cards and automobile loans to levels that some economists say may curb spending growth.

Chairman Ben S. Bernanke and his Fed colleagues are betting on such a slowdown to justify easing the pace of rate increases without raising inflation alarms. Bernanke has signaled the Fed will tighten credit further if the risk of faster inflation grows. The central bank's policy committee predicts U.S. economic growth of 3.5 percent for the full year; that compares with 4.8 percent in the first quarter.

"The Fed's been stepping on the brakes for a while," said Edward McKelvey, senior U.S. economist at Goldman, Sachs & Co. in New York. "Pretty soon the car is going to start slowing down."

Last month, a Goldman Sachs index of financial conditions averaged its highest, or least favorable, level since May 2003. Yet the index, which incorporates short- and long-term rates, stock prices and the trade-weighted value of the dollar, remained below levels reached during the economic expansion of the late 1990s.

Not Far Enough?

Such measures suggest the Fed still hasn't gone far enough with its rate increases and that today's expected boost may not be the last one. "The Fed will be concerned if their forecast doesn't unfold" for a slowdown in consumer spending, said Mickey Levy, chief economist at Bank of America Corp. in New York.

And even with money more expensive, inflation remains a threat. The Fed's preferred inflation gauge, which excludes food and energy, rose 2 percent for the 12-month period that ended in March, at the top of Bernanke's comfort zone of 1 to 2 percent.

The rate-setting Federal Open Market Committee convenes today in Washington for its third regularly scheduled meeting this year, and second since Bernanke, 52, succeeded Alan Greenspan. The meeting began at 8:30 a.m. Washington time, 30 minutes earlier than usual. An announcement is likely at about 2:15 p.m.

All 91 economists surveyed by Bloomberg News expect the panel to raise the 4.75 percent benchmark rate for overnight loans between banks by a quarter percentage point to 5 percent, the highest since April 2001.

Two Years Ago

The rate stood at 1 percent when the Fed began the increases almost two years ago. The Fed's campaign has lasted longer than most economists expected last year at this time, when the median forecast in a Bloomberg survey was for a fed funds rate of 4.25 percent at the end of June 2006.

Some Fed officials "expressed concerns about the dangers of tightening too much, given the lags in the effects of policy," according to minutes of the last meeting on March 27- 28. "However, members also recognized that in current circumstances, checking upside risks to inflation was important to sustaining good economic performance."

Investors are watching to see how much room the Fed leaves in its statement today for a potential pause in June after Bernanke indicated in congressional testimony last month that such a move was under consideration.

The Fed rate increases failed to trigger gains in long-term rates until recently, a phenomenon Greenspan termed a "conundrum" last year.

No More Conundrum

There's little talk of a conundrum anymore. The average U.S. fixed rate on a 30-year mortgage rose for the sixth straight week to 6.59 percent, the highest since June 2002 and up from 5.75 percent a year ago, according to Freddie Mac. Last week's rate was still below the 7.56 percent average from 1996 to 2000.

Toll Brothers Inc., the largest U.S. builder of luxury houses, said last week that fiscal second-quarter orders plunged 33 percent, while Hovnanian Enterprises Inc., the largest builder in New Jersey, reported orders for the quarter ended April 30 fell 20 percent.

"It's clear that the Fed's rate hikes have materially affected the mortgage market," though not retail sales and consumption, Levy said. That "has surprised a lot of forecasters and, I think, has surprised the Fed."

Higher wages helped boost personal spending a greater-than- expected 0.6 percent in March, the latest month for those figures. Incomes rose by the most since September and more than double the previous month's increase.

Wages Jump

U.S. employers added fewer jobs than expected in April, while wages jumped because factories filled more high-paying positions, the government said last week. Those reports led traders to reduce bets on a June rate increase by the Fed.

According to minutes of the FOMC's March meeting, members observed that the "ongoing cooling in the housing market would act to restrain residential construction and growth in consumption, but business and household confidence and supportive financial conditions would help to foster growth in employment and incomes, keeping consumption and investment on a solid upward track."

That depends on whether wages do in fact keep pace with costs. The monthly interest payment on a $30,000 home equity line of credit taken out at a 4 percent rate two years ago would have increased to $194 from $100 because of the Fed moves, said Greg McBride, senior financial analyst at Bankrate.com in North Palm Beach, Florida, which tracks consumer interest rates.

Fixed Rates

"Banks are seeing increased runoff" of their home equity lines of credit as consumers move to lock in interest costs with fixed-rate loans, said Fritz Elmendorf, a spokesman for the Consumer Bankers Association, a trade group in Arlington, Virginia. Credit card and home-equity rates tend to be tied to the prime rate, which major banks set three percentage points above the fed funds rate.

The rise in Fed rates will also sock consumers with higher payments on adjustable-rate mortgages that come up for new rates this year after an initial three-year period with the lower interest rate.

The Fed moves have made saving more attractive, with one- year certificates of deposit, for example, paying at levels unseen in more than five years. The U.S. savings rate, though, has been negative for 10 of the 12 months through March, a signal consumers are dipping into savings to maintain spending.

To contact the reporter on this story:
Scott Lanman in Washington at  slanman@bloomberg.net

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