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Expect a rate hike March 21

  • 2000 7 Mar
Expect a rate hike March 21
Reprinted with permission from World Finance Net IPO Newsletter, written by Alexander Frauenfeld

With the next Federal Reserve meeting, on March 21, just down the road, it's time to take stock of what has happened and is happening to the economy, in anticipation of the next interest rate action.

In a widely expected move, the Fed raised short-term interest rates by a quarter point last month in an effort to slow the seemingly unstoppable US economy and ensure prices for goods and services do not begin to creep higher. It also shot a warning over Wall Street's bow that it will raise rates again if the economic celebration now in record territory does not die down a bit.

It was tough love for an economy just celebrating its record 107th month of uninterrupted expansion. Annual growth is currently above 4%. Unemployment is at a generation low and continuously declining. Prices for goods and services are stable if not falling. Record stock market gains have more people participating in the market than ever. Rising real estate values in 1999 have given Americans more paper wealth than ever before.

The problem is not what is going on now. It is what could potentially happen in the future that Greenspan's Fed is protecting us from. The economy is chugging along at a pace that is really exceeding the speed limit, and that could cause some damage in the long run.

For consumers, a Fed rate increase means it is going to cost them more in interest payments on their credit cards and lines of credit at the bank. The Fed hopes such increases will make us think twice about charging up that dinner or buying a new car. The same goes for companies, who will be dishing out a little more to borrow money to finance their new ventures. Indeed, the nation's banks wasted little time getting down to business after last month's increase, raising the prime rate they charge their best customers by a quarter point.

For financial markets, the rate increase last month and the short announcement that followed was not all that big a deal. Stocks turned in a mixed performance for the day, while bonds held on to gains already made before the announcement crossed computer screens mid-afternoon. Surging economic growth, resilient consumer spending, strong manufacturing output, a vigorous housing market, and almost non-existent disruption from the Y2K date change rollover already had convinced most market participants that the Fed would act to slow the economy's progress. The increase was already "built into the market," and there was no surprise reaction.

Still, while the move was expected, the strong wording of the statement was not, and the more recent Humphrey-Hawkins Testimony by the Fed Chairman once again emphasized that. Greenspan remained "concerned" that demand for American goods and services could continue to exceed the supply available, "even after taking account of the pronounced rise in productivity growth." In its revamped statement accompanying the rate decision, the Fed also said that the balance of risks toward inflation gaining speed down the road were "heightened," suggesting more rate increases might be in store. "Against the background of its long-running goals of price stability and sustainable economic growth and the information currently available, the Committee believes the risks are weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future," read the Fed's one-page statement.

Curiously, one of the main missing ingredients in the Fed's battle against inflation has been inflation. With the exception of commodities such as oil and natural gas, prices for computers, wireless phones, DVD players and other such goods have actually declined. Higher productivity and fierce competition have kept retailers from raising prices while still improving profit margins.

Yet, there is growing concern among investors and Fed officials that the momentum of the US economy, at some point, will spur faster inflation. Much of the economy's momentum is the byproduct of hungry US consumers who, despite three quick rate increases from the Fed (beginning last summer), have not learned to keep their wallets and checkbooks in their pockets. Americans' spending rose almost twice as fast as incomes in December, while personal savings fell to an all-time low. That followed on the heels of another economic report showing the economy grew at a scorching 5.8% pace in the fourth quarter, the strongest showing of the year and well above what economists, and the Fed, consider a comfortable rate of advancement for the economy.

One clear threat to US economic expansion is growing debt levels. Private-sector debt, according to the Commerce Department, is at the highest levels since the mid-1980s. While it is not the same as 1987, when the stock market crash led to a savings and loans debt crisis, it could potentially wreak mayhem on the economy if people and business are suddenly forced to repay loans with money they no longer have.

That is why the Fed is taking steps now to slow things down, raising the Fed funds rate in steady, quarter point increments to avoid causing a significant reaction either within the economy or within financial markets. Whether the economy needs Fed fiddling to slow it down, or whether gains in technology and productivity can allow growth to continue without fueling an increase in prices, is the great debate on Wall Street, Main Street and at the Fed.

In fact, this economy appears to have so much momentum that, even though speed limits have been raised, it is still going a little too fast. Given that momentum in the economy at the end of last year and in the early part of this year, the FOMC will undoubtedly raise interest rates yet again. Look for another 25 basis points increase at the March 21st meeting, and unless there are some signs of a slowing economy, that move could easily be 50 basis points, even though that would be going against Greenspans incremental style. The financial markets agree, judging by the yield on Fed funds futures contracts, which indicate where the market expects rates will be down the road.

The larger question is how many more rate hikes it will take to make the Fed comfortable that the pace of the economy will slow enough to avoid an increase in consumer prices?

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