LONDON, 22 August 2005 — The Federal Reserve of the United States raised recently short-tern interest rate target by a quarter percentage point to 3.5 percent without giving any signs of the next move, or moves. I believe this is the beginning of a series of steady hikes and the question remains: How much higher would the Fed go?
Earlier this year, financial markets were worried that faster economic growth in the US will mean an early start to a rising rate cycle, in the short-term. So what happened to the inflationary pressure that Alan Greenspan was concerned about last month? Was this the “measured pace” alluded to in recent testimonies? It was, in my opinion, a conservative and cautious approach by the Fed chairman in response to the unpredictability in oil prices and the underlying cost to consumers.
That was last month, so what caused the change in the Fed’s thinking last week?
First, consumer spending remained strong despite higher energy prices. Second, employment improved steadily with 207,000 new jobs last month, the biggest gain in three months and, finally, inflation rate remained relatively low. The Fed’s decision to raise interest rates was influenced by those factors as it felt that the economy could resume its strong performance despite the gradual rate hikes. That was a view less hawkish than the statement made by the Fed in last June!
The real question is how much interest rates will rise and how drastic the economic effects of its rise will be. The Fed will strive to manage interest rates to stimulate or neutralize economic growth and that would correspond with business productivity or capacity, as well as the labor force needed to accommodate such growth. When the economy is close to outstripping capacity, i.e. demand exceeds supply thus pushing up prices and wages, the Fed will have to raise interest rates to effectively slow the economy.
But how factual is this economic growth? Last year, consumer retrenchment had been the main reason for the weakness in the US economy. There were several reasons for that including rising energy prices, high debt levels and a softer job market.
Rising energy prices were probably the single biggest drag on consumer spending and they are likely to remain a drag for sometime. Oil markets are tight and supply disruptions in key exporting countries as well as reduced refinery capacity have steadily pushed prices higher. Higher oil prices have created a dilemma for Greenspan: Either to focus on boosting growth or on fighting inflation!
Indeed, a balancing act which the Fed had to maneuver skillfully. The anxiety subsided as the economy turned around this year and as positive data started to emerge demonstrating a swing in economic activities thus leading the Fed to re-adjust its interest rate policies accordingly.
The more interesting question is what lies ahead and what are the prospects for growth. Let us first agree about two things: First oil prices will stay high, if not escalating higher and second, consumer spending will grow at perhaps a faster rate than anticipated. These two, amongst other factors, will determine to a large extent the Fed’s tendency vis-à-vis interest rate trends.
Is the Fed action to increase interest rates a timely one? One would argue that the pace for increase should be faster in order to counter the possible rise in the inflation rate.
This might be true given the economic growth acceleration coupled with the rise in labor cost and housing prices. Main concern relates to the housing market in the US. Home prices appear to be high in dollar terms, but does that mean that prices are being high or the dollar value being low?
A valid argument stipulates that extended low mortgage interest rates might have created a “housing bubble” that could cause an economic backlash when it bursts. What happens to the housing market when interest rates start to climb?
Last week’s increase was the 10th in a series of equal steps in just over a year to lift interest rates from a four-decade low of 1 percent in mid-2003 by 225 basis points to its current 3.5 percent. The Fed might have to raise interest rates again when the Federal Open Market Committee meets on Sept. 20 with further increases to follow as the FOMC turns more aggressive in order to cope with the faster growing economy anticipated in the United States.
(Habib F. Faris is vice president at Clariden Bank, London)
(The information contained here in is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information.)
