Fed Appears Poised to Raise Rates Soon

WASHINGTON —  Federal Reserve officials signaled Tuesday that they were likely to raise short-term interest rates soon, a development that could test the recovery’s strength, chill some overheated housing markets and fundamentally change financial calculations for millions of consumers and businesses.

The Fed’s monetary-policy panel, the Federal Open Market Committee, said it was leaving its benchmark short-term rate unchanged for now at 1%. But citing a strengthening economy and job market, it dropped a previous pledge to remain “patient,” replacing it with a promise to proceed at a “measured” pace.

Some analysts interpreted the statement as a sign the Fed would begin raising rates this summer, reversing a series of reductions that took rates to lows not seen since the 1950s and provided powerful fuel for a sputtering economy.

“This is a turning point,” said economist Brian Wesbury at the Chicago investment banking firm of Griffin, Kubik, Stephens & Thompson. “The Fed started cutting interest rates in January of 2001. It’s been a long time since interest rates went up.”

Few economists believe the expected increases in short-term rates will derail the recovery or create economic mayhem. Analysts said the rate hikes were likely to be gradual -- no more than 0.25 or 0.50 percentage point at a time.

Rates on long-term debt, which are determined by market forces, have already begun to rise in anticipation of the Fed’s tightening, a strengthening economy and rising inflation. Rates on 30-year, fixed-rate mortgages climbed to 6.01% last week, up from a recent low of 5.38% in March.

Analysts said the eventual ratcheting up of short-term rates would create real pain for some overextended borrowers, hit some regions such as Southern California harder than others and send at least mild tremors through an economy that is more rate-sensitive than in the past.

“It will have a dampening effect,” said Mark Zandi, chief economist at Economy.com, a research firm. “It would only be a significant blow to the economy if rates spiked higher very quickly. So far that doesn’t look likely.”

The rate hikes will affect a broad range of consumer and business borrowing keyed to short-term rates, including adjustable-rate mortgages, home equity and auto loans and some credit card accounts.

Consumer debt has risen to near-record levels, and nearly a quarter of household borrowing is subject to floating-rate payment adjustments.

Lower-income households are particularly exposed, analysts said. They tend to have higher levels of adjustable-rate debt, and some have stretched their finances to the limit to buy homes and cars and other big-ticket purchases. Personal bankruptcies and mortgage foreclosures have already risen to unusually high levels.

“The consumer has gotten addicted to incredibly cheap financing and has been induced to buy a lot of stuff on zero-percent financing and take out bigger and bigger loans,” said Lehman Bros. chief economist Ethan Harris. “There’s no question the consumer is vulnerable.”

Rising rates are likely to take the wind from the sails of the nation’s housing market, which has experienced record sales and robust price appreciation in recent months, economists said. They also are expected to choke off the mortgage refinancing boom that helped propel the recovery.

The hikes are expected to hit some regions harder than others. The exposure is greatest in areas where home values have appreciated the most, such as the East and West coasts.

Residential real estate has been particularly strong in Southern California. Heavy demand for housing has been a catalyst for the creation of thousands of jobs -- from mortgage banking to construction to manufacturing of stone and glass. Soaring home values have been a prime driver of consumer spending in California, as many homeowners tapped into their rising home equities or simply opened their wallets because they felt good about their personal finances.

“Housing plays a larger role in the collective psyche of households in Southern California than it does nearly everywhere else in the country,” Zandi of Economy.com said. “If higher rates shut down that cash machine, the impact to Southern California will be measurable.”

Using data from the Fed and credit bureau Equifax, Zandi estimated that housing and its effect on other sectors and consumer spending added 1.38 percentage points to the nation’s real economic growth last year -- or about 44% of the inflation-adjusted growth.

The effects of Fed tightening could be felt throughout the world, analysts said. Low global interest rates have prompted some international investors seeking higher returns to pour money into stocks and bonds in developing countries in Asia and Latin America. Some of that capital could flee when U.S. rates begin rising, and governments may find it difficult to stay solvent if creditors insist on higher rates for future borrowing.

Rate hikes could have U.S. political repercussions as well. If rising rates appear to slow the recovery or pinch pocketbooks, the negative fallout could create problems for President Bush, whose economic stewardship is under attack by Democratic challenger Sen. John F. Kerry. On the other hand, if rising rates are viewed as a byproduct of growing prosperity, that could benefit Bush.

Also, higher rates will provide better returns for savers in money-market funds and short-term savings accounts.

The Fed’s monetary-policy committee said it was leaving unchanged the interest rate charged on overnight loans between banks. It has held the benchmark “federal funds” rate at 1% since last June to help the economy recover from a series of recessionary shocks in 2000 and 2001 and to ward off a possible deflationary cycle that could have done even more damage.

Economists have been predicting for months that the Fed would begin raising the federal funds rate this year, probably in small increments. The rate hikes were generally expected to continue until the federal funds rate reached a more “neutral” level -- one that neither stimulated nor slowed economic growth -- probably in the 2% to 4% range, by the end of 2005.

The statement issued at the conclusion of Tuesday’s meeting suggested the hikes could come sooner rather than later, analysts said. The statement said the economy “is continuing to expand at a solid rate and hiring appears to have picked up.” It dropped a reference to the possibility of deflation and noted that risks to economic growth and price stability now appeared evenly balanced.

Although inflation remains low by historical standards, recent indicators suggest price pressures are building. Last week, the Commerce Department reported that one key measure of inflation registered 2.5% in the first quarter, up from 1.5% in the final quarter of 2003.

Some analysts said they now believed the first rate hike could come in June, and probably no later than September. “It’s pretty much guaranteed that we’ll have a rate hike by August,” said Wesbury, the Chicago economist.

Much will depend on the next round of economic indicators, particularly Friday’s release of job market figures for April. Another sign of growing strength came Tuesday, when the Commerce Department reported that factory orders surged 4.3% in March, the biggest monthly gain in nearly two years.

The Fed’s shift “is a signal to people that this recovery is real,” said Robert MacIntosh, chief economist with Eaton Vance Management, a Boston investment firm. “It’s a confirmation that this economy is in darned good shape.”

The stock and bond markets -- which had already declined in recent weeks in anticipation of rising rates -- reacted relatively mildly to Tuesday’s news. Stocks rose moderately while bond prices fell, raising their yields.

The last time the Fed began raising rates after a prolonged period of keeping the money supply plentiful was in February 1994, when it began pushing the federal funds rate to 6% from 3% over a 12-month period.

Those rate hikes roiled the bond market and contributed to the financial collapse of the Wall Street brokerage of Kidder, Peabody & Co., the Orange County bankruptcy and an economic plunge in Mexico.

Although Fed officials have long denied that politics sway their decisions, some economists said they believed Fed Chairman Alan Greenspan and his colleagues were mindful of the election cycle. That doesn’t necessarily mean they will hold off on hiking rates, analysts said.

“The election does not stop the Fed from tightening,” said Maury Harris, chief economist for UBS Warburg in New York. “There’s a clear history of Fed tightening in election years. If conditions warrant it and they don’t do it, all it does is damage the Fed’s credibility.”

Some analysts said the timing of the fall election might even prompt the Fed to begin raising rates sooner. Better to get the first increases out of the way during the summer, they said, than to crash the party just before the November balloting.

Times staff writer Don Lee in Los Angeles contributed to this report.