UNEMPLOYMENT DROP FUELS TALK OF INTEREST-RATE HIKE.

Byline: Martin Crutsinger Associated Press 

The likelihood that the Federal Reserve will increase interest rates has jumped dramatically following a steep decline in the unemployment rate, in the view of many top economists.

That position was bolstered by comments from Fed Governor Laurence Meyer, who pointed to Friday's unemployment report and various other statistics that showed the economy has developed ``considerable momentum.''

``We are in a circumstance in which a prudent central bank must exercise heightened surveillance of the inflationary risks and stand ready to respond if necessary,'' Meyer told the National Association of Business Economists in Boston on Sunday night.

Meanwhile, a prominent group of economists known as the Shadow Open Market Committee that closely monitors Fed policy said Monday that the Fed should move to tighten credit conditions. The members said the action was likely to occur at the central bank's next meeting in two weeks.

``We believe it is appropriate now to take a slight pre-emptive tightening action,'' said Allan Meltzer, head of the group and a professor at Carnegie Mellon University.

Other private economists said they believed central bank policy-makers themselves were preparing financial markets for a rate increase, the first such move since February 1995.

In addition to Meyer's remarks, they said a number of Fed governors and regional bank presidents who serve on the 12-member Federal Open Market Committee, the group that sets interest rate policy, have spoken about the need for increased vigilance given the economy's surprising strength in recent months.

Fed Chairman Alan Greenspan, delivering the Fed's midyear economic report to Congress in July, pledged that the central bank would move quickly to increase interest rates, ``should the weight of incoming evidence persuasively suggest an oncoming intensification of inflation pressures.''

While Fed officials passed up opportunities to raise interest rates at their July and August meetings, believing the economy was beginning to slow, a string of reports since then have called that view into question. Factory orders and housing sales took unexpectedly big jumps in recent reports and then Friday's report showed unemployment dropping in August to its lowest level in seven years, 5.1 percent, down from 5.4 percent in July.

``I think the unemployment report is the straw that breaks the camel's back,'' said David Jones, an economist at Aubrey G. Lanston & Co. in New York. ``We have reached the point where we are likely to see accelerating wage and price pressures and that is what Meyer was hitting at in his remarks.''

The Fed would prefer to keep policy unchanged in the closing months of a presidential campaign to avoid charges that it is trying to influence the election, but analysts said a rate move now would not be unprecedented.

The Fed cut rates in September 1992, a move that the Bush administration complained came too late to help its candidate win a second term. And it raised rates in August 1988, when Bush was running against Michael Dukakis.

``The history of election years shows clearly that the Fed will move if they think there is a need to do so,'' said Lyle Gramley, a former Fed governor and now economic consultant for the Mortgage Bankers Association.

Many analysts said they believed the Fed will feel the need for only two or three modest quarter-point tightening moves that would drive the federal funds rate, the interest that banks charge each other on overnight loans, from 5.25 percent now to 5.75 percent or 6 percent.

That would be far different than the last string of rate hikes from February 1994 to February 1995 when the funds rate was doubled, up from 3 percent to 6 percent.

Because of this more moderate outlook for rate hikes, economists continued to forecast economic growth and no recession in the coming two years.

The National Association of Business Economists in its latest quarterly forecast predicted Monday that the gross domestic product will rise by 2.3 percent this year and by the same rate in 1997, up from growth of 2 percent in 1995.