Interest rates head higher before formal Fed shift

WASHINGTON -- Consumers will not have to wait until this summer to see what kind of impact a Federal Reserve decision to move to higher interest rates would have on their pocketbooks. The Fed's policy of telegraphing its intentions has already sent consumer rates higher.

And analysts believe those rate increases in home mortgages and bank certificates of deposits will continue to occur in coming months, even though they don't think the Fed will actually start raising the key interest rate it controls until, probably, August.

Through a series of carefully timed comments by Federal Reserve chairman Alan Green-span and other officials, and subtle changes in the announcements issued by the Fed's interest-rate setting Federal Open Market Committee, the central bank is sending a clear message that rates will be headed higher.

"The Fed so far has done a very good job with its open-mouth policy of preparing the markets for an eventual rise in interest rates," said Sung Won Sohn, chief economist at Wells Fargo & Co. in Minneapolis.

The Fed's main policy lever is its target for the federal funds rate, the overnight rate that banks charge each other. The funds rate, an important determinant of short-term rates, has been at a 46-year low of 1 percent since last June.

Financial markets certainly are not waiting for that rate to climb. Over the past seven weeks, the longer-term rates controlled by markets have been on a significant rise.

Rates for 30-year fixed-rate mortgages, which hit a low for this year of 5.38 percent the week of March 18, rose above 6 percent last week to 6.01 percent, according to Freddie Mac's nationwide survey.

That increase tracks the rise in Treasury's benchmark 10-year note, which has gone from 3.76 percent seven weeks ago to above 4.5 percent this week.

So what should consumers do in this environment of rising rates?

Analysts suggest that those chronic procrastinators who have not yet refinanced their home mortgages should waste no time in doing so.

They have missed the four-decade low for 30-year mortgages of 5.21 percent set in June 2003, but refinancing at rates just north of 6 percent would still save money.

Savers who have suffered through extremely low rates on their bank certificates of deposits will benefit in a rising rate world.

Greg McBride, financial analysts at Bankrate.com, a personal finances Web site, said rates on five-year certificates of deposit, now at a national average of 3.13 percent, are up significantly from their low of 2.45 percent hit last July.

Analysts advise that savers ought to continue to favor shorter-term maturities of a year or less over the next six to 12 months so that they can invest in longer-term CDs as rates rise.

"There is no incentive to lock up multiyear maturities with interest rates still at such low levels," McBride said.

Consumers with credit card debt, auto loans and most home equity loans still have a bit of a reprieve on higher interest rates because this debt is generally tied to the Fed's federal funds rate.

Analysts advise paying off as much of this debt as possible in the next few months, before the Fed ratchets rates. Commercial banks' prime lending rate, the benchmark for millions of short-term consumer and business loans, is still at 4 percent, but it will be heading higher in lockstep with changes in the federal funds rate.

To predict how high rates will go, analysts pointed to the Fed's own statement Tuesday, which said that the central bank believes with inflation low and plenty of slack in the economy, any rate increases are likely "to be measured."

Many private economists interpreted that as meaning gradual quarter-point rate hikes which will start in August and then occur roughly at every other meeting over the next two or three years.

That could take the 1-percent funds rate up to 2 percent by the summer of 2005 and 3 percent by the summer of 2006. That's a far more gradual move than the 3-percentage point hike in the funds rate that the Fed engineered over a 12-month period in 1994, which sent shock waves through financial markets at home and abroad, pushing the Mexican peso into crisis and driving debt problems of Orange County, Calif.

No one is predicting that type of calamity this time. But analysts warn there could be fallout from rising rates in such areas as housing sales, which have been driven to record levels by super low mortgage rates, and in auto sales, where popular zero-rate financing incentives have been driving sales.

"These transitions rarely happen smoothly, but the Fed does have room to go slowly because inflation is so low," said Mark Zandi, chief economist at Economy.com.

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