The red-hot U.S. economy, which has barreled through obstacles as formidable as the stock market crash with barely a flinch, may have finally gotten enough interest-rate medicine to start cooling down.
With a conspicuous discount rate increase this week highlighting its monetary agenda, economists said the Federal Reserve Board is engineering a slowdown that should ease the inflationary pressures that have worried financial markets.The Fed's discount rate increase on Tuesday to 6.5 percent from 6.0 percent, combined with its more subtle tightening of credit by pushing up the federal funds rate, has prompted major U.S. banks to lift their prime lending rates a half-point to 10 percent. The federal funds rate is the rate banks charge each other for overnight loans.
The discount rate hike was also viewed as a signal that the central bank stands ready to cut the money supply even more if it sees the need, which some economists think it will.
"We're having this rise in rates because the fundamentals of the economy are running like a 12-cylinder Ferrari," said economist Thomas Carpenter of ASB Capital Management Inc. in Washington.
"The rates are being engineered by a Federal Reserve which I think is doing the right thing," Carpenter said.
But the rate hikes will not slow economic growth until after the November presidential election, economists said, adding that it could take until the middle of next year for inflationary pressures to abate.
So far, the handful of more minor credit-tightening moves the Fed has made since Chairman Alan Greenspan took the reins of monetary policy from veteran inflation-fighter Paul Volcker have done little to slow the economy.
Now in its 69th consecutive month of expansion, the longest ever in peacetime, the economy grew at a brisk 3.4 percent annual rate in the first three months of 1988 and at 3.1 percent in the second quarter.
With 2.25 million jobs created since January and the unemployment rate near a 14-year low, economists say growing pressure for higher wages, along with steady consumer demand, capacity strains on some industries and drought-induced shortages are combining to build inflationary pressure.
By raising interest rates, economists said the Fed hopes to slow growth to a more manageable rate of 2 percent to 2.5 percent by dampening consumer and business spending, while allowing export sales to assume a larger role in the economy.
But fine-tuning the economy has its risks.
Too much tightening could push the dollar higher, threaten the progress the United States has made in improving its trade balance and push the economy into a recession.
Too little could fail to contain price increases and shatter the confidence the financial markets have in the Fed as an effective inflation-battler.
The Fed's previous half-point increase in the discount rate on Sept. 4, 1987 was followed six weeks later by the October stock market crash, which forced the central bank to abruptly loosen its grip on credit.
But despite an initial selloff in the stock market following the latest discount rate hike, which knocked 3.4 percent off the Dow Jones Industrial Average in two days, economists see little chance of another market disaster.
"Before the stock market crash last year, the market didn't have confidence in Alan Green-span," said economist Michael Penzer of Bank of America.
With the Fed chairman's financial acumen now more established, the disparity between long-term and short-term interest rates less drastic and the dollar stronger than it was last year, Penzer said a crash is much less likely.
"The Fed doesn't want a recesion, they want to temper this thing at the edges," he said. "They're going about it the right way. The only question is how much of this tightening will it take to get economic growth to 2 percent to 2.5 percent."
Another difference, said ASB's Carpenter, is that the U.S. trade gap, which was deteriorating last year, is now improving and the stock market is at a lower base than it was on Oct. 19 when $500 billion in wealth evaporated in a single day.
"The sort of valuation excess that was in the stock market last year is no longer there," Carpenter said. "There are some fundamental differences."
If the financial markets belive the economy is slowing in response to the Fed's recent moves, Carpenter said the stock market could rally.
"But if the perceptions are that Fed must tighten more, then that will cause the stock market to sell off by more than just a token amount, which I think has been the case in the last couple of days," he added.