Thursday, March 30, 2006

Is a 16th Rate Hike in the Cards?

On Tuesday afternoon the Federal Reserve Open Market Committee announced the fifteenth consecutive interest rate increase , just as expected by practically everyone on wall street. The latest increase of twenty five basis points(0.25%) raises the short term interest rate in the United States to 4.75%, a level not seen during this century. The Federal Reserve is not done yet raising rates. The future markets in Chicago are pricing in an 80% chance of a further rate hike during the next Fed meeting in May. A few economists are even predicting further rate hikes in the summer.

Those who support the current policy initiatives by the Federal Reserve are , as a general rule, worried about inflationary pressures. They tend to point to the low current unemployment rate of 4.8% in addition to the increase in manufacturing capacity utilization of over 81% and conclude that the economy is perilously close to its full employment potential. They argue that unless we start tapping on the brakes in order to slow down the economy then we run the risk of setting in motion a "demand pull inflation".

A small but vocal group of economists dismisses these fears as unfounded. They present the counter argument that such increases in the interest rate are unwarranted since the labour market has at least seven million officially unemployed persons, not to mention the millions of discouraged workers and those that are working involuntarily on a part time basis. Furthermore, this group believes that consistent improvements in productivity will ameliorate any upward pressure on wages.

Who is right and who is wrong? Probably the truth is somewhere in between.The fed should at a minimum stop after the next interest rate increase in May in order to observe and study objectively the new economic data.


elizabeth said...

I'm afraid the current administration is not known for stopping to examine data (e.g. w.m.d. in Iraq). What are we potentially facing if the Fed goes ahead with continuous rate hikes through the summer?

ghassan karam said...

La Liz,
When I look into my crystal ball, albeit a cloudy one, I see the following:

(1) Corporate America is flush with cash on its books. As a result the interest rates will not be a major drag on investment.

(2)The Fed will overshoot its target. It often does and I don't see why it is different this time. The reason is quite simple: Fed policy reacts to targets but by the time the data in question is collected then the Fed will be aiming at yesterdays' problem.

(3)Housing as an ATM will go in reverse. I believe that over one quarter of outstanding home mortgages will come due for an interest rate resetting within less than a year. Obviously the monthly payment for all of them will be adjusted upwards. This money needs to come from somewhere!!!

(4) An interest rate of over 5.5% will take its toll on the P/E ratio of equity valuations. This will at a minimum restrain the increase in the value of portfolios and consequently will impact consumer spending negatively.