Neither Trend Sharp Enough to Hurt

Many economists expect inflation to continue drifting higher and for the Federal Reserve to raise interest rates at least once more in the next 12 months, but those developments are unlikely to do much damage to banks.

Consumer prices increased at a 2.1% rate for the 12 months through July 31, up from the 1.4% pace earlier this year. Strong consumer demand and rising wages are likely to keep pushing that rate higher, economists said. Inflation for 1999 as a whole should register 2.5%, said Michael Moran, chief economist at Daiwa Securities America Inc.

The Federal Reserve boosted rates in June and August, pushing the federal funds rate on overnight loans between banks to 5.25%. The creep in inflation will lead to at least another quarter-point rate hike, perhaps next month, economists said.

Banks are expected to feel some pain from the Fed tightening but not a lot. "There is a reluctance for banks to expand their balance sheets rapidly when the central bank is tightening, and there is concern about the credit quality of banks' loans," said Richard Hoey, chief economist at Mellon Bank Corp. "But the Fed is tapping on the brakes to tighten, as opposed to putting up a brick wall. As a result, the magnitude of these effects will be moderate rather than severe."

Moreover, with bank shares already having dropped this year because of rising interest rates, "there is a chance that the worst for bank stocks is over," Mr. Hoey said. From the beginning of July through Thursday, the Standard & Poor's Bank Composite index of 31 stocks fell 16%.

As for inflation, buoyant demand, rising labor costs, rising commodity prices, economic recovery overseas, and a falling dollar will push it higher, economists said. Consumer spending surged 4.6% in the second quarter and shows little sign of slowing down. "Stock market and real estate wealth are clearly keeping consumption relatively strong,'' said Stephen Axilrod, an economic consultant who was formerly a top official at the Fed.

As for wages, hourly earnings rose 3.8% in the 12 months through July, accelerating from a 3.5% rate of increase through May. "Probably the single most important factor" in pushing inflation higher "is the tightening labor market,'' said Edward McKelvey, senior economist at Goldman, Sachs & Co. The unemployment rate was 4.2% in August, near a 29-year low.

Just last month, Boeing Co. offered workers wage increases of 4% in the first two years of a new contract, exceeding the industry average.

On the commodity side, the Journal of Commerce Index, which measures the price of 17 industrial commodities, gained 8.5% from its low in early March through mid-August. And oil prices have soared about 60% this year.

"We don't have the downward effect of commodity prices" that we had last year, said Elliot Platt, chief economist at Donaldson, Lufkin & Jenrette Securities Corp. He also pointed out that economic recoveries in Asia and Latin America are lifting prices. For example, both the South Korean and Brazilian economies expanded in the first half of 1999 after contracting last year.

The dollar's drop also is fueling inflation, by pushing import prices higher, economists said. The U.S. currency fell to a seven-month low against the yen last week. Slowing productivity gains are inflationary too, analysts said. Nonfarm productivity rose 0.6% at an annual rate in the second quarter, decelerating from a 3.6% first-quarter gain. "You don't want to look at just one quarter, but that serves as a reminder of the cyclical element to productivity," said Daiwa's Mr. Moran.

Though inflation is creeping higher, it is not about to soar, analysts said. Heated global competition means businesses "don't have pricing power," said James Glassman, senior economist at Chase Securities Inc. The explosion of commerce over the Internet will also limit price increases, he said. Mr. Moran forecast inflation of 3% next year.

Though that would be almost double 1998's rate of 1.7%, "if you went back a decade or two and said inflation would be 3%, people would have said 'great,' " said Mr. Hoey of Mellon Bank.

So the rise in inflation will be enough to make the Fed raise rates further but not enough to make it tighten aggressively, analysts agreed. "We see moderate moves," said Goldman's Mr. McKelvey. By the end of next year, the fed funds rate may be at 5.75% -- half a percentage point above the current level, he said.

Banks will suffer only a bit from higher rates, economists said. "Obviously banks are interest-rate-sensitive," Mr. McKelvey said. "Their cost of borrowing goes up, and there is less demand for loans" when rates rise. "But it won't be a major impact."

One helping factor is that long-term interest rates would increase in tandem with short-term rates as the Fed tightens, meaning that what banks would lose in borrowing short-term funds they would gain in lending long-term funds, said DLJ's Mr. Platt.

And as long as the economy avoids a hard landing, banks won't suffer major problems with bad loans, said Mr. Axilrod, the consultant. Most analysts expect economic growth to total at least 2.5% next year.

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