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 interest rates 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.

But in Orange County, where the economy is poised for recovery this year, economists said they do not believe the Fed’s action will have negative repercussions.

The announcement that the central bank is 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.

“It’s been expected,” said Anil Puri, dean of the Cal State Fullerton economics department. “It probably happened a little sooner than most preople thought, but it is consistent with the Fed’s long-term policies of low inflation and stable growth and I don’t believe it will damage the county’s recovery process.”

Walter Hahn, chief economist for the Orange County office of national accounting and consulting firm Kenneth Leventhal & Co., said he found the interest rate increase a refreshingly keen move.

“It’s nice to see the Fed out in front of things for a change,” he said. “It’s usually behind the curve.”

Both economists said that if the increase in the bank borrowing rate ultimately causes mortgage interest rates to rise, that probably would also have a beneficial impact in Orange County.

The last time mortgage interest rates went up a quarter of a point, it spurred a home sales increase because people who had been holding off on home purchases decided to take the plunge before borrowing for a mortgage got any more expensive.

Costa Mesa stockbroker Jeffrey Kilpatrick said he believes the interest rate increase inevitably will be seen by investors as a good move that will boost output in businesses across the county.

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 national 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%.

Times staff writer John O’Dell in Costa Mesa contributed to this report.

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