Fed Hikes Interest Rate; Stocks Slide : Economy: Central bank boosts federal funds ceiling from 3% to 3.25%. Anti-inflation measure jolts Wall Street, but White House officials signal support.

WASHINGTON —  The Federal Reserve Board, concerned that the economic recovery may fuel inflation, raised a key interest rate Friday for the first time in nearly five years, signaling an end to an era of declining loan costs and sending a shiver through Wall Street.

The central bank’s action in raising the benchmark interest rate for federal funds from 3% to 3.25% sent the Dow Jones industrial average tumbling by nearly 100 points. By the end of the day at least one bank had reacted by raising its prime rate.

Clinton Administration officials, however, generally supported the maneuver by the Federal Reserve, whose actions are independent of government control. The federal funds rate is the interest banks pay on overnight loans to each other.

The decision is unlikely to exert much pressure on interest rates paid by consumers, at least in the short run, economists said. And if the Federal Reserve succeeds in holding down inflation, longer-term interest rates paid by consumers for home mortgages, auto loans and other borrowing also will rise only slightly, some economists said.

But the increase is still a shot across the economic bow: Nearly five years after the Federal Reserve began lowering rates to combat recessionary trends, the central bank believes that the recovery is solid enough that it can return its attention to preventing inflation by raising the cost of borrowing.

The rate increase spawned forecasts of more rises to come. Economist Lawrence Kudlow of Bear, Stearns Inc. predicted that the Clinton Administration is in for “a much bumpier economic ride than they think.”

Lyle Gramley, a former Federal Reserve governor, said that the central bank most likely will undertake “a series of tightening moves to raise interest rates.”

“They’re taking a gradual course,” he said. “This is the beginning. We will have to look forward to increases every six to eight weeks in short-term interest rates until the end of the year.”

Such a course, Gramley said, would “avoid inflation and in the process ensure a longer recovery.”

Although Alan Greenspan, chairman of the Federal Reserve Board, made it clear in testimony to Congress on Monday that rates would be raised, the bank surprised officials with its method of disclosing the increase. Rather than simply adjusting the rate, as is customary, the bank issued a formal statement explaining its intention to use tighter money to fight inflation and keep the economy from overheating.

“The decision was taken to move toward a less accommodative stance in monetary policy in order to sustain and enhance the economic expansion,” the Fed said in a written statement disclosing the plans of the Federal Open Markets Committee, the bank’s key rate-setting panel, which had cast a 10-0 vote in favor of the higher rate.

The statement continued:

“Chairman Greenspan decided to announce this action immediately so as to avoid any misunderstanding of the committee’s purposes, given the fact that this is the first firming of reserve market conditions by the committee since early 1989.”

Greenspan and others have expressed concern that the strengthening national economic recovery--which is far from evident in Southern California--would lead the nation into a new round of inflation. Because inflation is more difficult to turn around once it has set in, they have said, an effective preemptive strike would be to limit the money supply by making borrowing more expensive.

Inflation in 1993 was 2.7%, the lowest rate since 1965, with the exception of a 1.3% rate in 1986, but such a low rate is not expected to hold. Another measure of economic health, the 30-year mortgage rate average, has begun to creep up, from a 25-year low of 6.74% in October, to the current average rate of 6.97%.

The Clinton Administration expressed support for a rate increase earlier in the week. President Clinton signaled Monday that he had no objection to a small increase in short-term rates, as long as the longer-term rates, which have a more direct effect on consumers, could be held down. And on Friday, the Administration said that it had included slightly higher interest rates as a factor in preparing its economic forecasts.

“We still think the economy will grow at 3% this year,” Treasury Secretary Lloyd Bentsen said Friday. “Inflation appears to be well-contained at the present time.

“The Federal Reserve is an independent central bank, and we respect its independence,” he added.

Laura D’Andrea Tyson, who heads the President’s Council of Economic Advisers, said that the move is “consistent with the continuation of a solid and sustained economic expansion.”

Tyson, Bentsen, and Labor Secretary Robert B. Reich were dispatched to the White House press briefing room to publicize the Administration’s cautionary message that the rise in the short-term interest rate and new unemployment figures should not be read as signs of looming economic turbulence.

Nevertheless, the financial markets greeted the announcement with a selling spree.

According to preliminary calculations, the Dow Jones average of 30 industrials fell 96.24, or 2.43%, to 3,871.42. It was the greatest point loss since Nov. 15, 1991, when the industrial average fell 120.31 points. Declining issues outnumbered advances by nearly 7 to 1 on the New York Stock Exchange, with just 314 up, 2,037 down and 402 unchanged. Bond prices fell as well.

Chicago-based Harris Trust & Savings Bank, a subsidiary of the Bank of Montreal, raised its prime lending rate to 5.75%, from 5.5%.

While decisions made by the Federal Reserve can have a direct impact on some loans, the greatest effects ripple through the economy indirectly, with commercial banks following the central bank’s lead and money managers reading the tea leaves of the central bank’s actions and reacting accordingly.

Consumers feel the impact in rates they pay for borrowing on auto loans, mortgages and other long-term purchases as well as on such short-term debt as credit cards.

Whether Friday’s decision stalls inflation before it occurs is a matter of debate among economists.

It may turn out to be counterproductive because fears of higher rates to come could spur consumers to make big purchases, further fueling an economy that the rate increase is meant to cool, Kudlow said.

“This will create expectations that interest rates have bottomed out and future rates will be higher,” he said. “Therefore consumers and businesses will accelerate purchasing decisions to beat higher future costs.”

But he said such a reaction would most likely last no more than three to six months.

The Fed last raised the federal funds rate on Feb. 23, 1989, pushing it up to 9.75%. In repeated attempts to stimulate the economy, the bank then cut the rate 23 consecutive times, eventually bringing it down to 3%, the lowest figure in three decades, on Sept. 4, 1992.

A Turning Point

The recent Federal Reserve targets for the federal funds rate, which peaked at 9.75 in spring of 1989.

Feb. 4, 1994: 3.25%

Sept. 4, 1992: 3.00%

July 2, 1992: 3.25%

April 9, 1992: 3.75%

Dec. 20, 1991: 4.00%

Dec. 6, 1991: 4.50%

Nov. 6, 1991: 4.75%

Oct. 30, 1991: 5.00%

Sept. 13, 1991: 5.25%

Aug. 6, 1991: 5.50%

April 30, 1991: 5.75%

March 8, 1991: 6.00%

Feb. 1, 1991: 6.25%

Jan. 8, 1991: 6.75%

Dec. 19, 1990: 7.00%

Dec. 7, 1990: 7.25%

Nov. 16, 1990: 7.50%

Oct. 29, 1990: 7.75%

July 13, 1990: 8.00%

Dec. 20, 1989: 8.25%

Nov. 6, 1989: 8.50%

Oct. 16, 1989: 8.75%

July 27, 1989: 9.00%

July 7, 1989: 9.25%

June 6, 1989: 9.50%

Background

Federal Reserve, the nation’s central bank, uses interest rate increases as a tool to keep inflation pressures in check. While inflation is low now, recent signs of economic strength have raised fears that inflation could accelerate. Higher rates tend to cool inflation pressures by making it more expensive for individuals and businesses to borrow money. The stock market plunged in reaction to the Fed’s decision. While many strategists don’t consider the stock rally over, the sharp reaction could mean investors are in for an unpredictable ride after a three-year bull run.

Source: Times staff and wire reports