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Economists Say Orange County Bankruptcy Is Factor In Fed Rate Hike Decision

December 15, 1994

NEW YORK (AP) _ The financial crisis in Orange County, Calif. could persuade the Federal Reserve to postpone another interest rate hike until January, economists say.

Few Fed watchers believe Orange County’s massive losses from interest-rate sensitive investments will be the main factor in the central bank’s decision about whether to raise rates again. But many say the county’s problems will be one reason why the Fed - whose policy-making committee meets next week - may decide to wait until early next year to tighten credit again.

″I don’t think the Fed will want to exacerbate the problems in Orange County,″ said Sung Won Sohn, chief economist at Norwest Corp., a Minneapolis- based banking firm.

The affluent Southern California county declared bankruptcy last week after its investment fund, which it had built up through heavy borrowing, sustained massive losses from risky investments known as derivatives. It is the largest U.S. municipality ever to go bankrupt.

Higher rates will worsen the crisis because the fund, which has already lost about $2 billion, invested in various types of securities and notes that lose value as interest rates rise.

Sixty percent of the fund’s investments are now in derivatives, although the county put the securities up for sale Wednesday. For every 1 percent that interest rates rise, the investment pool loses another $300 million, county official said this week.

There’s little question that rates will continue to go up over the next few months, so the fund, unless it has sold off all its derivatives, will suffer regardless of whether the Fed acts next week or next month. A postponement would give Orange County a little breathing room.

The Fed’s Federal Open Market committee meets next Tuesday, and observers have speculated for weeks that the FOMC would vote to raise rates by .50 or .75 percentage point because the economy shows few signs of slowing down.

The Fed has pushed rates up six times this year to put the brakes on the economy, which tends to fuel inflation when it expands too quickly. But economists said the Fed may postpone a rate hike until the January FOMC meeting for a number of reasons - with Orange County the one that tips the scales.

A spate of economic data this week has suggested the economy continued to expand in November but with scant signs of inflation. This could justify postponing a rate hike until January.

Moreover, the Fed may want to wait until data reflecting activity in December is available before deciding when to tighten credit further.

Raising consumer borrowing costs in the midst of the Christmas shopping season would not be a very popular move in the view of some members of Congress, analysts point out.

″A December tightening is not a high probability at this point,″ said Dan Seto, an economist at Nikko Securities Co. International Inc.

Some analysts believe Orange County’s financial crisis is not an isolated case and that other municipalities in California, Texas, Florida and elsewhere could face similiar problems with their investment portfolios.

The Fed may want to wait to see if the crisis hits other cities.

″There is a small army of auditors scurrying around the country right now looking at municipal investment funds,″ said David Orr, chief economist at First Union Corp. ″It will be difficult to get a read on the value of any interest-rate sensitive investments in the midst of another rate hike, so I would think that the Fed would have to be taking that into consideration.″

Fed officials have said they are monitoring the Orange County financial crisis, but have made no indication the problems would be a factor in a rate decision.

Economists said it would be out of character for Fed Chairman Alan Greenspan to base policy decision on a financial crisis. Greenspan sounded warnings months ago that interest rates would rise, and he wants the Fed’s monetary policy to be independent of the behavior of financial markets.

But the Fed has acted publicly and behind the scenes during financial catastrophes. The most obvious example is the stock market crash of 1987, when the Fed eased credit to cushion the crash’s impact on the economy.

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