WASHINGTON The latest increase in short-term interest rates fulfilled bond market wishes for a tighter policy from the Federal Reserve, but it also increased the chance that the economy will slow to a crawl in 1995.

Increasingly, Fed officials find themselves caught between the pressures of financial markets and an uneasy public that will be paying more for adjustable-rate mortgages, home equity loans, and other popular types of credit.

Interest rates are now higher than they have been in three years, wiping out any bond market gain that resulted from President Clinton's deficit reduction program. The rate on 30-year, fixed-rate mortgages has reached 9.20%, up from only 7.08% a year earlier.

Short-term rates, which are most directly affected by the Fed when it tightens credit, are also up sharply. Commercial banks have pushed up the prime lending rate to 8.5%, from 6% at the beginning of the year, and one-year. adjustable-rate mortgages have climbed to 6.10%, from 4.20%.

Analysts at DRI/McGraw-Hill Inc., the forecasting firm in Lexington, Mass., believe the economy's pace will slacken considerably by next summer and won't be far from grinding to a halt. They predict the Fed will raise short-term rates one more notch, to 6%, while economic growth slows to a little better than 1% beginning next spring.

"I believe that we are getting close to a traditional recession," said Roger Brinher, executive director of research at DRI.

Mr. Brinner was surprised by the renewed burst of spending last summer by households with incomes over $40,000 for cars, furniture, and other high-priced durable goods. This spending spree gave the economy an unexpected lift and forced the Fed to take a more aggressive stance in tightening credit, he said.

Other economists are not as pessimistic about the economy's prospects in 1995; they see a more gradual slowdown in growth, to about a 2.5% rate essentially the pace forecast by the Clinton administration.

But there is a little chill in the air as the economy finally shows signs of slowing in response to the upturn in rates. The Commerce Department reported last week that housing starts and permits fell in October, and some analysts suspect consumers will find themselves spent out and loaded with debt after Christmas.

Uncertainty about rates and the economy's direction next year is souring the stock market. The rise in rates has also clobbered the bond market as mutual fund investors flee to the safety of the banks, where rates of 5.5% on six-month certificates of deposit suddenly don't look so skimpy.

And while inflation shadows keep flickering across Wall Street, the official

government price reports continue to look terrific.

The Labor Department said consumer prices in October were up only 2.6% from the year before.

Analysts insist that some upturn in inflation is in the pipeline and that the Fed's strategy of moving early to contain inflation is sound.

But the ranks of the doubters are growing. "Our ability to smart-bomb this economy with a preemptive strike is a little arrogant, and the risks are high," said Jerry Jasinowski, president of the National Association of Manufacturers.

The Bond Buyer is a sister publication of American Banker.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.