Moody's Lonski: Fed rate increase could take steam out of Wall Street.

While a better-behaved inflation report lifted municipals Friday, one economist warned that a tightening of monetary policy expected this week could hurt public coffers in the New York metropolitan area over time.

"What oil used to be to Texas, interest rates are to New York," said John Lonski, a senior economist at Moody's Investors Service. What happens to interest rates, and consequently to the financial services sector, "is of the utmost importance," he said.

Municipal bonds overall ended up 1/4 point Friday in light trading. Yields on high-grade issues fell by two basis points overall to more in spots. Dollar bonds ended 1/4 point higher.

On Friday, the Labor Department reported that the consumer price index rose 0.3%. in July, matching economists predictions, dead on. The core rate, which excludes food and energy items, climbed only 0.2%. Economists had expected a 0.3% increase.

The CPI report proved more bond-friendly than expected, Nonetheless, most of those surveyed on Friday expected a 50-basis-point tightening in the federal funds rate to come out of tomorrow's Federal Open Market Committee meeting.

However, one municipal trader interviewed Friday said he stands firmly in the no-action camp. "I'm a minority. I think they do nothing," the trader said, adding that he saw no "magic about the August date" when the FOMC meets.

Lonski said that while Friday's CPI figure does take some pressure off the Fed, he would not be surprised to see a 50-basis-point increase in the fed funds target rate by this time next week. The economist said that part of the reason the bond market steadied on Friday is that participants believe the Fed will produce a 50 basis point credit tightening to show the bond market it means business in fighting inflation. A 25-basis-point increase could leave investors wondering if the Fed does indeed mean business, he said.

Lonski predicts that if the Fed does hike rates and long-term interest rates eventually go higher, trouble could loom for the financial services industry, if the tightening cycle that begin in spring of 1987 is any indication. He noted that the New York metropolitan area is heavily dependent on the industry.

In the case of the 1987 tightening cycle, which was interrupted by the October stock market crash, the financial services area was the first to feel the recession that would eventually grip the rest of the U.S. economy, Lonski said, citing "a decline in underwriting activity" that year and "difficult trading conditions."

"I'm not going to say there are any ratings implications," Lonski said, adding, however, "It's got to hurt the [New York metropolitan area] economy." Troubles in the financial services area could result in "slower-than-expected growth of tax revenues" in the tri-state area surrounding New York City.

One municipal analyst, who requested anonymity, said investment banks are more than just trading and underwriting businesses, and he does not foresee cuts that would compare to 1987. The industry could see some retrenchment the in stock and bond underwriting areas that have beefed up staff over the past three to four years in response to brisker business, he said.

That aside, Robert W. Chamberlin, a senior vice president and supervisory municipal analyst at Dean Witter Reynolds Inc. noted that New York State, along with Florida, are two states where a big demand for tax-exempt paper is going unmet.

"The relationship between what we've got, and what the demand is, is a significant imbalance," Chamberlin said. An overall shortage of supply is continuing to help municipals outperform Treasuries, he said.

"We continue to feel that municipals will not run in tandem with Treasuries," Chamberlin said.

New York and Florida, which traditionally have been heavy demand states, are now facing tax-exempt bond shortages once limited to midwestern agricultural states, he said. New paper tends to be scarce in those states, but they don't see the demand that states like New York and Florida do.

While logic might suggest that demand for their paper might lure New York and Florida issuers to market, Chamberlin said that although he can't be sure, he suspects they feel little pressure.

With 30-year Treasury bond nearing the top end of its current 7.25% to 7.50% range, issuers probably feel yields are unlikely to go lower, and they have nothing to lose by waiting, he said.

In addition to lower overall new supply, "retail is an ongoing force" helping municipals, Chamberlin said. The analyst added, however, that "it's still a lot easier to sell retail inside 12 years."

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