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Surge in Rates May Hurt Pillar of the Economy

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If cheap mortgages have kept the economy afloat, the economy may have just sprung a leak.

A little more than a month after the Federal Reserve reduced its overnight lending rate to just 1 percent, mortgage rates have shot up as investors have soured on the bond market in part because of confusion about the Fed's intentions in managing the economy.

This has abruptly stalled plans by thousands of homeowners to refinance their houses at even lower rates than they already enjoy. The pace of home loan refinancing has fallen by half the last several weeks, according to bankers and analysts.

If the higher rates persist, they will make it more expensive for people to buy houses or to borrow money against their houses to pay for renovations, furniture and even cars. That would damp a principal source of consumer demand over the last two years, a period when consumer spending has been one of the few sources of economic growth.

Higher rates could also lead to more expensive loans for automobiles; robust car sales have been another pillar of the economy the last few years.

Businesses, meanwhile, still gun shy about spending money on new factories and equipment, may have to contend with higher borrowing costs as well. So will the federal government itself, just as tax cuts and spending increases are forcing it to borrow huge sums to cover the largest deficits in history.

It remains to be seen whether last week's surge in longer-term interest rates is just a blip or the start of a trend. Either way, however, it is remarkable as a demonstration of the limits of the Fed and its chairman, Alan Greenspan, to force the hand of the nation's financial markets.

The Fed may have lowered its federal funds rate, the rate it charges on overnight loans, but investors have ignored the move and pushed up interest rates on longer-term Treasury bonds.

Analysts say a big reason investors are marching in the opposite direction is that they have new doubts about both the Fed's ability and willingness to take drastic steps if the United States slips into the kind of price deflation that plagues Japan.

"It looks to some people now as if the emperor has no clothes," said Sung Won Sohn, chief economist at Wells Fargo, referring to Mr. Greenspan. "The Fed doesn't have much ammunition left, and if they use it, the markets will just demand more."

The astonishing divergence of Fed policy and the reaction of financial markets poses a challenge to Mr. Greenspan, who has until now enjoyed a nearly mythic reputation for his power to make the enormous American economy move to his tune.

Analysts say the Fed's sudden loss of influence stems from several factors. The first is a sudden reappraisal of the Fed's intention; after having fretted for months about the dangers of deflation, suggesting that it would use highly unconventional techniques to flood the markets with money to fight it, Mr. Greenspan backtracked last month to the disappointment of many bond investors.

The Fed also disappointed many investors by cutting the overnight federal funds rate by only a quarter- point on June 25.

On a more positive note, investors are also reacting to new data suggesting the economy may be strengthening after all. If that proves to be true, the Fed would be expected to raise rates at some point in the not too distant future.

Higher interest rates would make bonds, with their fixed interest rates, less appealing to investors. Bond prices would fall to compensate for the decline in demand.

But analysts say there is also an important new technical issue at play, one that may have caught Fed officials by surprise. That issue has to do with the nation's mortgage lenders, who are responsible for more than $5 trillion in home loans.

To protect themselves from borrowers' paying back their loans early, mortgage lenders hedge their loan portfolios in part by buying up Treasury bonds. But as interest rates began to creep up, the nation's biggest players abruptly adjusted their strategy and started selling bonds or derivative securities tied to them. Lower prices for Treasury bonds translate directly to higher interest rates earned on those bonds.

Since mid-June, yields on 10-year Treasury notes, which move in the opposite direction from the prices, have climbed from about 3.3 percent to 4.28 percent today. That affects the rates financial institutions charge for countless other kinds of long-term loans, from mortgages to car loans. Rates on mortgages have shot up more than one percentage point the last two weeks, from slightly over 5 percent to about 6 percent.

Rising interest rates also affect the Federal government's growing budget deficit, which the Bush administration expects to reach $455 billion this year.

Though many economists contend that big government deficits eventually lead to higher interest rates as the government begins to crowd the markets with its huge borrowing needs, most analysts say the recent surge in interest rates is not a result of the newest news on deficits.

Analysts say the increase in this year's expected deficit is tiny compared with the total credit market, and they note that investors were already expecting this year's deficit to exceed $300 billion.

John Makin, a senior economist at the American Enterprise Institute, said the most important reasons for the startling run-up in interest rates lies with the Federal Reserve.

Mr. Makin noted that Mr. Greenspan and other top Fed officials had put heavy emphasis on their worries about deflation, an across-the-board decline in prices. Beyond letting it be known they would reduce the overnight federal funds rate, Fed officials also began suggesting they would use "unconventional" methods to flood the markets with money if the federal funds rate declined to nearly zero.

As outlined by Mr. Greenspan and other Fed governors, notably Ben S. Bernanke, the Fed was prepared, if necessary, to move beyond setting rates for overnight lending and to start buying back longer-term Treasury securities, which would have directly lowered longer-term interest rates.

Expectations about lower long-term rates peaked in mid-June, not long before the Federal Reserve's Federal Open Markets Committee was scheduled to meet to decide on further reductions in interest rates.

As it happened, the Fed disappointed many investors by reducing interest rates by a quarter-point, and it continued to surprise them afterwards by backing away from talk about "unconventional" methods of fighting deflation.

The credit markets soured far more on July 15, when Mr. Greenspan testified before Congress. In that testimony, he was surprisingly optimistic about the economic outlook and led many analysts to believe that the Fed might actually raise interest rates by early next year.

Equally important, according to many analysts, Mr. Greenspan said it was "extremely unlikely" that deflation would pose a big enough risk to require pushing down longer-term interest rates with unorthodox tactics.

"My view is that the Fed has less confidence in the effectiveness of those operations," said Laurence H. Meyer, a economist and former Fed governor. But, he added, investors felt the Fed's conflicting signals had whipsawed them.

Most analysts are convinced last week's rise in interest rates was aggravated by an unusual new technical factor. That factor was the hedging activity of the nation's huge market in mortgages, a market worth more than $5 trillion that is substantially bigger than the market for Treasury bonds.

Mortgage lenders offset the risk that borrowers would repay their loans early by buying up Treasury bonds that guarantee interest rates over 10 years. But as rates began to creep up last month, mortgage lenders expected a big drop in mortgage refinancing activity and began to sell off Treasury bonds. That helped push interest rates higher, creating what amounted to a vicious cycle of rising rates.

Technical issues aside, some analysts say the process might not have started if the Fed had been clearer about its plans. "People were happy to take risks when the Fed was very accommodative," Mr. Makin of the American Enterprise Institute said. "I think they should have left the throttles on full."

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