ANALYSIS-Bracing for a more aggressive Fed
By Knut Engelmann
WASHINGTON, March 26 (Reuters) - Better get ready for the big one.
If the roaring U.S. economy does not slow down very soon, the Federal Reserve may well decide to ditch its slow-motion policy of gradual interest rate rises and switch into higher gear, raising rates by more than the quarter-percentage point increments world financial markets have become used to.
Already, some of the Fed's top brass are pushing for higher rates in the face of torrid growth rates that few believe can be sustainable for much longer without a rise in inflation.
So far, the hardliners have been held back by Fed Chairman Alan Greenspan, a firm believer in the virtues of incremental changes in short-term interest rates. How much longer he will be able to keep the flood gates closed is anybody's guess.
Starting last June, the Fed has raised short-term rates five times, pushing up the key overnight federal funds bank lending rate in a series of quarter-percentage point steps.
But bit by bit since the start of the year, momentum for a more aggressive campaign of monetary tightening has been building on the rate-setting Federal Open Market Committee.
Minutes of the FOMC's February meeting, released last week, revealed ``some' of the group's 10 voting members had argued for a half-percentage point rise at the time.
In the end, they went along with the majority and settled on a quarter-point move, presenting a united front only in the knowledge that the Fed's tightening cycle was far from over.
``Others', as the minutes put it with customary discretion, took comfort in the fact that the option of half-point rate hikes was still very much on the table for later in the year.
``This is the first sign that the Fed may move more aggressively in future meetings,' said Tom Gallagher of political analysis firm ISI.
The Fed has not raised rates by more than a quarter percentage point at a time since the mid-1990s, when it was in the midst of another tightening cycle.
PULLING THE TRIGGER
So far, the case of the Greenspan-led gradualists has been bolstered by still-tame inflation rates. Discounting the effect of higher energy prices, core inflation in the world's biggest economy has remained remarkably restrained, even in the face of the nation's tightest labor market in a generation.
But with demand growth continuing to outstrip the economy's capacity to produce, Fed officials and analysts alike say the outlook for inflation is decidedly unclear. A sharp spike in headline inflation could play into the hardliners' hands.
``In order to embark on a more aggressive course, the Fed would need a strong inflation trigger,' said Richard Berner, chief U.S. economist at Morgan Stanley in New York.
It is that very uncertainty over the future course of inflation -- held down in part by strong gains in productivity growth that itself has confounded forecasters -- that helps Greenspan justify his penchant for gradualism.
The smaller the steps, the easier it is to backtrack later, or, as the Fed minutes put it, ``calibrating those actions to the emerging situation'.
But in the face of unrelenting economic growth, running in the neighborhood of five percent so far this year, and financial markets that have all but ignored the Fed's monetary tip-toeing, that line gets increasingly hard to defend.
GETTING BUSY
``The question is not why the Fed is tightening,' said Lyle Gramley, a former Fed governor who now advises the Mortgage Bankers Association. ``The question is why don't they get busy. They're way behind the curve.'
Sharp gains in equity prices, and declines rather than increases in some market-determined rates such as segments of the mortgage market are working squarely against the Fed.
Its goal of engineering a soft landing that will let the record-breaking U.S. expansion run its course may prove to be elusive unless official rates rise substantially, argues Don Hilber, an economist at Wells Fargo Bank in Minneapolis.
``The Federal Reserve has failed to slow down the forces leading to strong economic growth,' he said in a research note. ``Soft landings exist only in models. The boom-bust business cycle is alive and well.'
For now, most Fed watchers still expect a quarter-point rate rise at the next FOMC on May 16 -- old habits die hard.
But a crop of fresh data to be released between now and then -- including consumer and producer price data for March and the first estimation of output growth over the January-March period -- could change that quickly.
And with some economists expecting the fed funds rate to rise to as high as 6.75 percent by year-end from 6.0 percent at present, at least one half-percentage point move until then would not come as a complete surprise to the market, either.
Mirroring growing uneasiness among investors over the rate outlook, inflation-sensitive Treasury bond prices fell on Friday after rallying for nine straight days. Yields, which move in the opposite direction to price, rose.
Gramley, for one, thinks the odds are good that Greenspan, who prides himself on his ability to build consensus among his fellow policymakers, will be swayed by the more aggressive rate talk. ``The chances are 50/50 that he'll go that way,' he said. |
