The Interest Rate Conundrum - Bloomberg:
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U.S. Economy: Fed Seen Fighting Inflation With Bigger Rate Hike
By Noam Neusner
Washington, May 10 (Bloomberg) -- Federal Reserve policy-
makers are expected to raise the overnight bank lending rate to
6.5 percent next week -- the highest in nine years -- after five
rate increases over 11 months have yet to slow the U.S. economy.
Unemployment fell to a 30-year low last month, consumer
spending grew in the first quarter at the fastest pace in 17 years
and labor costs rose during that period at the quickest rate in 10
years. Those signs of accelerating growth, coupled with data
showing consumer prices excluding energy and food rose in March at
the fastest rate in more than five years, suggest inflation is
starting to gather force.
``The Fed is now fighting rising underlying inflation as well
as unsustainably strong growth,'' said Neal Soss, chief economist
at Credit Suisse First Boston. ``That's likely to change the tenor
of policy deliberations.'' Soss and most other economists surveyed
by Bloomberg News are forecasting a half percentage point increase
next week in the overnight bank rate.
The Fed's policy-setting Open Market Committee, which meets
May 16, has been raising the interest rate that banks charge each
other for overnight loans in an effort to raise costs for all
borrowers and apply the brakes to an economy that's expanded by
more than 5 percent for three straight quarters.
``The growth rates we've seen in the last couple of quarters
in my view are unsustainable,'' said San Francisco Fed Bank
President Robert Parry to reporters last week.
The half-percentage-point increase expected next week would
be the biggest in more than five years, and follows five quarter-
point increases that pushed the overnight bank rate to 6 percent
today from 4.75 percent in June of last year. The overnight rate
hasn't been as high was 6.5 percent since January 1991.
What Slowdown?
Trouble is, consumer spending shows no sign of letting up.
Consumer credit rose at an 11.2 percent annual rate in the first
three months of the year, the fastest since 11.4 percent in the
fourth quarter of 1995.
The housing market -- one part of the economy that's expected
to be sensitive to changes in interest rates -- is red hot, even
as mortgage rates are rising. The average rate on a fixed, 30-year
home loan was 8.2 percent last month, about 1 1/4 percentage
points above the 6.9 percent average in April a year ago, before
the Fed signaled it was about to start raising rates.
Just today, however, the Mortgage Bankers of America reported
that applications for loans to buy houses surged to the second
highest level on record last week.
Home resales rose 1.5 percent in March following a 7 percent
increase in February. Sales of new homes rose in March at their
fastest pace in 1 1/2 years. And starts of new housing
construction in the first three months of the year were higher
than in the final quarter of last year.
Georgia-Pacific Group Chief Executive Altson ``Pete'' Correll
said the Fed's efforts are likely to have little impact on the
housing market for now. ``Our thinking is that as long as interest
rates are below double-digit levels, housing starts won't slow,''
Correll said.
Inflation Resurgence
On top of evidence that the economy isn't slowing, Fed
officials are concerned that inflation may be accelerating. The
consumer price index rose 0.4 percent in March -- the largest jump
since February 1995. Moreover, the personal consumption
expenditure price index, a measure in the GDP report tracked by
Fed Chairman Alan Greenspan, rose in the first quarter at the
fastest pace in almost six years.
``Last year, I didn't think we ought to shoot inflation''
that wasn't readily apparent, Dallas Fed Bank President Robert
McTeer said last week in a speech in Washington. ``More recently,
it's been showing signs of resisting arrest.''
The Fed must maintain a public stand against accelerating
price increases ``so that inflation expectations also relatively
low,'' Fed Vice Chairman Roger Ferguson said yesterday in a San
Francisco speech.
With all those things taken together, most analysts and
investors are looking for a half-point rate increase, the first of
that size since February 1995.
Still, there remains a possibility that the Fed will raise
the bank rate by only a quarter-point. Greenspan has said he
favors adjusting monetary policy in small, incremental steps,
figuring such moves reduce the likelihood of overstepping on
policy.
Gradualism and Credibility
``People think this gradualism is something they came up with
from out of the blue,'' said Jim Glassman, senior U.S. economist
at Chase Securities Inc. in New York. ``Gradualism is what has
given them credibility. Credible policy requires doing the right
thing at the right time, and not be seen going overboard.''
But Fed officials don't necessarily see a half-point increase
as going overboard, or as a retreat from a policy of gradualism.
``I think we've moved cautiously, but that doesn't mean we
only have a single note to play,'' Parry said yesterday. ``I'm not
sure I would consider a second note as being inconsistent with
caution.''
Investors appear to be prepared for the half-point increase.
The implied yield on Fed futures contracts for June is 6.47
percent, suggesting investors are nearly 100 percent certain the
Fed funds rate will average 6.5 percent in June. The yield on 90-
day corporate debt -- which tends to track the overnight bank rate
closely -- is now 6.51 percent, rising from 6.22 percent at the
end of April.
Some economists think such investor sentiment has made it all
but certain that policy-makers will take the larger step in rates.
That's because Fed officials generally prefer to ratify investor
expectations.
Fed Governor Laurence Meyer, speaking last month in Toronto,
said policy-makers see a benefits from market rates anticipating
Fed moves, because that has ``shortened the lag from increases in
the federal funds rate to the ultimate effect on aggregate
demand.''
The result, Meyer said, ``has actually added to, rather than
subtracted from, the effectiveness of monetary policy.''
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