WASHINGTON -- The latest increase in short-term interest rates fulfilled bond market wishes for a tighter policy at 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 of the gains that were built into the bond market from President Clinton's deficit reduction program. The rate on 30-year fixed mortgages has reached 9.20%. 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 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 over 1% beginning next spring.
"I believe that we are getting close to a traditional recession," says Roger Brinner, executive director of research at DRI.
Brinner was surprised by the renewed burst in spending by households with incomes over $40.000 for cars. furniture. and other high-priced durable goods during the summer. This spending spree gave the economy unexpected lift and forced the Fed to take a more aggressive stance in tightening credit. he says.
Other economists are not as pessimistic about the economy's prospects in 1995 and see a more gradual slowdown in growth to about 2.5% -- 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 fled to the safety .of the banks, where rates of 5.5% on six-month certificates of deposit suddenly don't look so skimpy anymore.
And while the 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% compared with a year earlier.
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.
