Lessons on rates from '94 fiasco

Stanley Lukowski is happy to see the economy coming back. A stronger economy should mean more customers, especially business customers, will borrow money from Eastern Bank, the Boston bank where Lukowski is chairman.

But in this case, prosperity comes with a price tag. The same good economy is boosting interest rates and still higher rates are probably on the way. Lukowski expects rising rates to put a dent in car sales and home sales, both of which have boomed in an era of ultralow rates. Still, as long as rates stay reasonable by historical standards, Lukowski assumes the bank -- and the economy -- should come out all right. "I don't think the world is going to come to an end," he said.

The US economy has been here before.

Ten years ago, the economy was picking up strength after a jobless recovery; financial markets were nervous about inflation; and the Federal Reserve was determined to raise interest rates. The Fed eventually raised rates seven times over 12 months, a course of action that slowed the economy, stalled the stock market and triggered isolated financial meltdowns both here and abroad.

With inflation reviving and stock markets around the world selling off in anticipation of a new round of rate hikes, there is a sense history is about to repeat itself. Kenneth Taubes doesn't think that will happen. "I assume the Fed doesn't want to create 1994 all over again," said Taubes, head of the bond department at Pioneer Investment Management, a Boston mutual fund firm.

Taubes expects rates to rise, but he predicts this time around the rate hikes will come more slowly, giving investors, consumers, and businesses more time to adjust. "The Fed will take its foot off the gas, rather than slam on the brakes," is how he put it.

Most analysts are equally optimistic. With inflation relatively low and the global economy working to keep prices in check, they say the United States should be able to weather modestly higher rates without enormous disruption. But at least a few economists add a caveat: When rates are rising, no one can ever be sure how high they will go or what problems those elevated rates might cause. "You never know where the fault lines are until they get exposed," said Mark Zandi, the chief economist at Economy.com, a Pennsylvania forecasting firm.

The parallels between 1994 and today are striking. Then as now, the economy emerged from recession without much momentum. The term "jobless recovery" was born in the early 1990s to describe the surprisingly sluggish performance of the economy. But in 1993 the job market came back to life and the economy entered 1994 with a bit of momentum.

Too much to suit the Federal Reserve. The Fed, led then as now by Alan Greenspan, worried that strong growth would lead to higher prices and a new outbreak of inflation. Inflation was moderate at the time -- prices were rising about 3 percent a year -- but Greenspan and company were worried about the future. In effect, they launched a preemptive strike to make sure inflation never had a chance to revive.

The medicine worked. Inflation never did rise. But the economy suffered as short-term interest rates rose from 3 percent to 6 percent and long-term rates such as mortgages rose commensurately. The economy never tumbled into recession, but by early 1995 it had slowed to a crawl as consumers and businesses cut back on spending. Bond investors lost money because bond prices fall when rates rise. The stock market, as measured by the Standard & Poor's 500, dropped 1.5 percent in 1994, a sharp break from the bull market of the 1990s. Higher rates hurt stocks by making other investments more attractive.

For some, the swift climb in rates proved disastrous. Orange County, Calif., had to declare bankruptcy when one of its investments -- a bet that rates would hold steady -- led to big losses. Mexico experienced a financial crisis in late 1994 as higher rates in the United States drew money out of the Mexican economy.

In the end, the US economy survived 1994 and went on to have a long and vigorous recovery. "You can argue that the Fed gave us the longest expansion in US history," said Richard DeKaser, chief economist at National City, a major Cleveland bank.

Recently, there have been signs that another solid recovery is taking hold. The economy expanded at a better than 4 percent pace in the first three months of 2004. Corporate profits are growing rapidly and the nation's factories are busy. Even the job market is on the mend. The government reported recently that the economy added 625,000 jobs in March and April, the best showing in years.

Inflation too has made a comeback. The prices of commodities -- everything from oil to milk -- have been rising swiftly, thanks to increased global demand. Higher prices for homes and hotels also reflect a healthier economy. A year ago the Fed was worried about deflation or falling prices. At its most recent meeting May 4 the bank noted that "incoming inflation data have moved somewhat higher."

At that same meeting, the Fed all but promised that interest rates would start to rise in response. The federal funds rate, the rate banks charge each other for overnight loans, has been set by the Fed at 1 percent, a 45-year low. The betting is the Fed will begin to raise that rate as early as its June meeting.

James Swanson is not terribly worried. Swanson is chief investment strategist for MFS Investment Management, a Boston mutual fund company. Swanson said that at the May 4 meeting, the central bank suggested rates would rise "at a pace that is likely to be measured." For Swanson, that measured pace is critical. "This isn't 1994," he said.

Swanson thinks the Fed can take its time raising rates because inflation isn't much of a threat today. Although commodity prices are rising, he said, wages are barely growing at all, the result of a relatively high 5.6 percent national jobless rate. As long as labor costs are contained, Swanson said, companies will not be under great pressure to raise prices.

Others point out that in contrast to 1994, the economy today is more globalized, which means companies can turn to foreign suppliers to hold down costs. The economy may also be more competitive. The airline industry offers a good example. Even at a time of rising fueling prices, fares on many flights are falling because so many airlines are battling for market share.

If the optimists are right, rates will rise gradually without posing much of a threat to the economy. Even interest rate-sensitive sectors like housing and autos should be fine as long as the rate hikes are modest, say analysts. The stock market may have a tougher time, although there have been periods in history when rates and stocks rose simultaneously.

The problem is forecasts are fallible. Conceivably inflation will prove to be a bigger problem than anticipated and the Fed will be forced to raise rates more steeply than expected, much like in 1994. It is also possible that rising rates will unearth problems that weren't visible before. "One of the side effects of low interest rates is that some patients get hooked on the medicine," said Allen Sinai, chief economist at Decision Economics in New York. "The trick is withdrawing the medicine in a way that doesn't kill the patient."

Charles Stein can be reached at stein@globe.com.