Analysts: Expected rise in rates would mean minimal effect

WASHINGTON -- Analysts say a widely anticipated one-quarter percentage point increase in the overnight bank lending rate would have little effect on the economy, while allowing Federal Reserve policy-makers to send a signal they'll be vigilant fighting inflation.

Only an explicit denial by Fed Chairman Alan Greenspan in one of his two appearances on Capitol Hill this week could derail expectations of a rate increase from the current 4.75 percent. The yield on the July federal funds futures contract, directly linked to the overnight bank rate, is at 4.97 percent, suggesting investors see an 88 percent chance of a Fed increase when the policy-making Open Market Committee meets June 29-30.

The consumer price index for May, also due out this week, could further fuel expectations for higher rates -- or raise doubts at the Fed if inflation appears tamer than a month earlier. Consumer prices rose 0.7 percent in April, the fastest pace in almost nine years. And with signs pointing to unrelenting consumer demand, several Fed officials have hinted in recent days that it's time to act. "The Fed has little more than credibility, so they want to defend it to the core" by raising interest rates at the first hint of inflation, said Diane Swonk, deputy chief economist at Bank One in Chicago. Still, a quarter-point increase "wouldn't be very consequential," she said. "Economies still expand with rising rates." That's just what's been happening. Market interest rates have jumped since FOMC members adopted a so-called bias toward tightening at their May 18 meeting. Yet consumers haven't cut back on spending. Chain store sales rose a larger-than-expected 6.8 percent last month, as shoppers scooped up women's fashions at chains, such as Limited, and electronics and other home goods at retailers, including Wal-Mart. And automakers had one of their best months ever in May, selling cars and light trucks at a 17.4 million annual rate. That happened even as the yield on 10-year Treasury notes, to which most auto and mortgage loans are tied, rose a third of a percentage point during the month. While the auto sales pace might be unsustainable, car and truck purchases shouldn't slow much in coming months even if the Fed raises rates, said Nicholas Lobaccaro, an auto industry analyst at Lehman Brothers in New York. A further half-point increase in interest rates would cut monthly vehicle sales by 150,000, or about 1 percent, he estimated. "The outlook is going to remain robust even if the Fed raised rates 50 basis points," Lobaccaro said. "It might mean $10 more a month" in a buyer's car payment -- which could easily be absorbed by industry discount and incentive programs, he said. "It would be inconsequential." The same could be true for the housing industry, one of the driving forces behind the current economic expansion -- in its ninth year and on track to be the longest ever. New and existing home sales set records last year, and while the rate of existing home sales fell in April, the level of sales remained high. U.S. new home sales reached the second-highest level ever in April, even as mortgage rates were starting to rise and prices hit a record. Builders attributed the sales increase to worries about higher rates. "People who have been sitting on the fence trying to make up their mind come out and buy," said Robert Toll, chairman and chief executive officer at Toll Brothers, the nation's No. 1 luxury home builder. Mortgage rates would have to rise 75 basis points to a full percentage point before "we would definitely see severe pressure on new construction," said Joe Anderson, executive vice president of consumer markets for Countrywide Home Loans, a subsidiary of Countrywide Credit Industries, the No. 2 originator of retail loans in the U.S. "There's a lot of room for that." Certainly higher mortgage rates haven't necessarily meant buyers are being priced out of the market. With a 7.23 percent mortgage on a $159,500 home, a buyer would pay $1,086 a month in principal and interest costs, compared with a $1,007 payment at 6.49 percent. "With the economic climate as healthy as it is, we expect sales to stay at current levels or even increase a bit," said Mike Ela, leader of Acxiom's DataQuick Products Division, which monitors real estate activity nationwide. Greenspan indicated last month that policy-makers are watching the housing boom's effect on the rest of the economy. "The home sales market is a critical factor of what's going on in retail sales" because buyers spend money furnishing and fixing up their new homes, he said. Many analysts argue that a boost in interest rates by the Fed, whether at its June 30 meeting or later, is already priced into stocks and bonds. "Business is great," said Uri Landesman, who helps oversee $350 million at Aaron Fleck & Associates, a Greenwich, Conn., money manager. "I'm feeling better about the market than I've felt in a while. I'm finding things to buy. I wish I had more cash." In fact, said Bank One's Swonk, Fed policy-makers created a future problem for themselves when they cut the overnight bank rate three times to its current level to ease financial market dislocations in the wake of Russia's debt default last August. "They put a floor underneath equities," she said. "Some of the steam the market's had could be due to the Fed and they don't want to leave it out there." Historically, stocks have gained even after the Fed raised interest rates, according to Ned Davis Research. After two fed funds increases, the S&P 500 has on average rallied 4.5 percent over the next 252 days, said Alan Skrainka, chief market strategist at Edward Jones, the St. Louis-based brokerage. "A Fed rate increase is not the end of the world," he said. The world itself isn't in jeopardy from a small Fed rate increase either, said Carl Weinberg, chief economist at High Frequency Economics in Valhalla, N.Y. "All the markets have put in at least a 25 basis point tightening already, so the adjustment is pretty much in place," Weinberg said. "The strength of the dollar has to do with good rates of return in the U.S., which will only continue if the Fed raises rates. So there'd not be a heck of a big difference."

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