If the nation's economy is actually growing fast enough to raise the risk of higher inflation, how much would interest rates have to increase to nip the threat in the bud?
Answer: Not much. A rise of one-half to three-quarters of a percentage point in short-term rates, and a smaller upward shift in long-term rates, would significantly dampen business conditions, according to most economists.
The Federal Reserve would thus not have to do nearly as much as it did three years ago to brake the economy. In 1994, the central bank doubled short-term rates during a yearlong credit tightening campaign to thwart inflation.
The current close-call situation is probably a big part of the reason the Fed has made no change for a year in the rates it controls-the overnight interbank lending rate, or federal funds rate, and the discount rate.
The central bank demurred on rates again last week when its monetary policymakers met. The next such session is scheduled March 25, with many economists now expecting an increase but a number of others saying they remain unconvinced.
"I don't think a March increase is a settled matter at all at this point," said Robert G. Dederick, an economic consultant to Chicago's Northern Trust Co.
The economist said he feels short-term rates could rise as much as three-quarters of a point this year but now sees that as the upper limit. And a stronger case for higher rates would have to emerge soon to prompt a Fed hike in March, he said.
That is also the view of Todd P. Martin, chief economist at People's Bank, Bridgeport, Conn. He said he doubts the Fed will change rates soon. And in any case, it would not move the federal funds rate above 6%, or three-quarters of a point beyond its current 5.25% level, he said.
He listed several reasons why. "The current expansion is already the second-longest postwar expansion on record," he noted, "and inflation remains under control."
Also, minutes of Fed monetary policy meetings from last summer reveal that some members of its open market committee were concerned about the impact of a rate hike on the financial markets, particularly the stock market.
"If the Fed raises rates, it will not be by much," said Mickey D. Levy, chief economist at NationsBanc Capital Markets Inc., a unit of NationsBank Corp.
Mr. Levy said he thinks labor productivity is being mismeasured, as Fed Chairman Alan Greenspan has also hinted. That would mean recent wage increases are not inflationary and that inflationary expectations priced into bond yields remain too high.
As a result, he said, he expects rates to fall by yearend, even if the Fed does temporarily tighten credit.
At its current level, around 6.75%, the 30-year Treasury bond, which is the benchmark long-term rate, already leaves little slack for economic growth, according to Donald G. Strazheim, chief economist at Merrill Lynch & Co.
"Our economy has not been able to sustain bond yields far above 7% in the last few years," he said in a recent message to clients. "When these rate have moved much above 7%, the economy begins to weaken fairly quickly."
That could happen later this year or more probably next year, Mr. Strazheim said. "We think at some point the economy will likely overheat, the inflation will pick up a bit, bond yields will rise, and the Fed will tighten.
"Then, with a lag, the economy will slow, and rates will fall like a rock," he said, describing what he called "a path to 5.5% bonds."