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Historically low rates are history

Analysts expect benchmark at 2% by year-end

The era of cheap money is over.

Federal Reserve policy makers are all but certain tomorrow to raise their benchmark interest rate for the first time in more than four years, ending an extraordinary period of historically low interest rates and beginning a cycle in which rates trend higher. By year's end, many economists expect the benchmark rate to double to 2 percent from its current 46-year-low of 1 percent, and then double again, to about 4 percent, by the end of 2005.

For consumers, this means higher interest charges for credit cards, home equity loans, and other borrowing tied to short-term rates. On the other hand, they'll earn higher interest on certificates of deposits and on savings and money market accounts.

Meanwhile, mortgages and other long-term borrowing rates, which moved sharply higher in recent months, are unlikely to rise much more over the balance of the year, economists said. That's because bond markets, which determine long-term rates, have already factored in the likely credit tightening by the Fed.

Financial markets and analysts, in fact, have anticipated a summer increase for quite some time as Fed officials, in speeches, congressional testimony, and official statements, have signaled that rates would have to rise as the economy improved. The Fed uses interest rates to manage the economy, cutting them to spur spending and demand when the economy is weak, and raising rates to slow economic growth when inflation threatens.

And in recent months, both the economy and inflation have rebounded. Since February, the economy has created nearly 1 million jobs, while consumer prices have soared at a 5.5 percent annual rate, compared to less than 2 percent in all of 2003.

Economists say the question is no longer when the Fed boosts interest rates, but how fast and how far. Just about everyone expects policy makers to begin tomorrow with a quarter-point increase and follow that up with a series of quarter-point increases over the next several months. Some, however, expect the Fed to later tighten credit more quickly, with at least one half-point increase before the end of the year.

''It's important that inflation not get away from the Fed," said Steve Andrews, vice president of Sovereign Bank's Capital Markets Group in Boston. ''And just as important, the Fed doesn't want to create the impression that they're letting inflation get away from them."

The Fed, other analysts added, faces a delicate transition. If it raises rates too quickly, it could choke off the recovery. Too slowly, and inflation could take off.

Analysts tomorrow will pore over the statement Fed officials release along with rate decisions to try to divine how quickly interest rates will rise. The key word: measured.

After the May meeting, policy makers said they would boost rates at a measured pace, widely interpreted as quarter-point increments. Should the statement drop or substantially modify that word, analysts said, it could mean that the Fed is becoming more concerned about inflation, and preparing to boost rates at more aggressive half-point increments.

Still, many analysts believe the Fed has room to raise rates gradually, and avoid the type of sharp, sudden increases of 1994 that caught financial markets by surprise and nearly drove the economy back into recession.

For example, Fed officials have more effectively prepared markets for the inevitable increase, letting them know through subtle word changes in speeches and statements that the rate stance was changing with economic conditions. So far, long-term rates have advanced in an orderly fashion.

In addition, economists said, the recent jump in inflation has been driven by short-term spikes in oil and commodity prices, which already appear to be abating, as opposed to the spiral of rapidly rising wages and prices that drove the runaway inflation of the 1970s. In May, for example, the rise in the so-called core inflation rate -- which excludes volatile food and energy products -- slowed to 0.2 percent, compared to a 0.3 advance in April. Economists consider the core rate a better indicator of long-term inflation trends.

That inflation has returned as a major concern is testament to the economy's remarkable turnaround. Just a year ago, the economy seemed so weak that the main concern was deflation, the corrosive downward spiral of prices that undermines the value of assets and lowers wages. The Great Depression of the 1930s is a famous example of the impact of deflation.

The Fed responded by cutting the benchmark rate to the lowest level since 1958, and holding it there over the past year. Now, the economy has responded just as hoped: Production is expanding, employment is rising, and prices are advancing, ending the deflationary threat.

And even if the benchmark rate doubles to 2 percent by the end of the year, it still remains historically low. When the Fed began raising rates following the recession of the early 1990s, the benchmark rate stood at 3 percent. Just over three years ago, when the Fed began cutting rates, the benchmark was 6.5 percent.

Nariman Behravesh, chief economist at Global Insight, a Waltham consulting firm, said that in many ways the impending rise in interest rates indicates that conditions are returning to normal, after an extraordinary economic struggle through terrorism, war, and global uncertainty.

''The economy is strong, and the Fed is again shifting toward fighting inflation," he said. ''And the reality is, it will take some time for interest rates to bite."

Robert Gavin can be reached at rgavin@globe.com.

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