By Martin Wolk Executive business editor
updated 9/21/2004 1:51:57 PM ET 2004-09-21T17:51:57

The Federal Reserve is expected to raise interest rates for a third time in three months Tuesday when policy-makers hold their final planned meeting before the November election. But even with interest rates still at historically low levels, some analysts believe Chairman Alan Greenspan and his colleagues could move to the sidelines soon because of the slow pace of economic growth.

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After Tuesday’s expected quarter-point hike, the benchmark overnight bank lending rate will stand at 1.75 percent, still well below the so-called “neutral rate” that would allow the economy to grow fast enough to create full employment without triggering a surge in inflation. Given current economic conditions, a neutral federal funds rate is generally estimated at anywhere between 3 and 5 percent. Analysts say the economy is not yet ready for rates to go that high, so a debate is growing among economists over how much higher the Fed will raise rates before moving to the sidelines.

Last week’s report that consumer prices inched up just 0.1 percent in August was the latest sign that inflation appears to have ebbed after a spike earlier in the year. Greenspan took note of the trend in his congressional testimony Sept. 8, saying that “inflation and inflation expectations have eased.”

And if inflation no longer appears to be a threat, the Fed might have the luxury of taking a long pause in its rate-hike cycle to see whether the economy gains more momentum, some analysts believe.

“One of the main points we’ve been trying to make since the Fed began this cycle is that the inflation numbers are really the key story here,” said Ethan Harris, chief U.S. economist for Lehman Bros. “If we hadn’t seen a pickup in inflation this year, the Fed would have taken a much more benign view of strong growth.”

Of course that strong growth, fueled in large part by the adrenaline rush of last year’s tax cuts and super-low interest rates, quickly gave way to what Greenspan called an economic “soft patch” blamed partly on rising oil prices.

Now that oil prices have eased a bit, many analysts are optimistic the economy will begin to pick up momentum. But while Greenspan testified that the expansion has “gained some traction,” evidence of renewed robust growth is sketchy.

Harris points out that even if the economy gains more steam, growth still will be far weaker than it was at the beginning of 2004, so he sees no need for what he calls a “death march to neutral.”

Other analysts agree the economy is in no shape to handle “neutral” interest rates, which would represent a sharp increase in the cost of borrowing for consumers and businesses. In fact David Rosenberg, chief North American economist for Merrill Lynch, said the neutral rate could be close to 3 percent, lower than where many others peg it.

In any case he pointed out that several Fed governors have hinted that the Fed could go on hold soon if the economy fails to pick up sharply. San Francisco Fed President Janet Yellen, while noting that the federal funds rate is still far below neutral, said the Fed might need “to consider pausing in the process of raising rates if slower growth in demand caused economic activity to slow down.”

“This concern seems less acute than it did a month or so ago,” she said in a speech Sept. 9. “But I still see it as a significant issue, warranting careful attention.”

Sung Won Sohn, chief economist for Wells Fargo, said the most likely course is that the Fed will raise rates a quarter-point Tuesday and then another quarter-point at its next scheduled meeting Nov. 10. That would bring the funds rate to 2 percent, “a nice round number,” and perhaps a good place to conclude phase one of the tightening cycle, he said.

He said Greenspan & Co. would like to get the rate back to about 4 percent by the end of 2005, but that would depend on stronger economic growth.

“Clearly the economy will have to do considerably better in 2005 to justify a 4 percent federal funds rate,” Sohn said. Like most Fed officials, Sohn is optimistic, but he acknowledges that so far this year growth has failed to meet expectations.

“It’s wishful thinking maybe, but I’m assuming oil prices will fall as a result of a decline in geopolitical tension and an increase in supplies,” he said. “The key assumption is that geopolitical tension and the price of oil will move in the right direction. If those things don’t happen we will have to alter our economic outlook.”

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