WASHINGTON - Strong data and past experience with incoming Federal Reserve chairmen has convinced investors the US central bank will lift interest rates to 5 per cent by July, but that bet looks premature.
Chairman Ben Bernanke testifies to Congress on February 15 and 16 against a backdrop of tightening labour markets and an expected bounce in growth from a very weak end to 2005.
His first meeting of the policy-setting Federal Open Market Committee as Fed chairman is on March 27-28. With policymakers having stressed that future policy decisions will be increasingly data-dependent, that is plenty of time for views on the economy to evolve.
But markets have already made up their minds. Financial futures have swung sharply in favour of a rise in the federal funds rate, now at 4.5 per cent, at the March meeting, his first at the helm since replacing Alan Greenspan. Currently they also signal an 80 per cent likelihood he will have pushed rates to 5 per cent by July.
Markets had put those chances at zero as recently as 3 weeks ago. But an unexpected drop in the unemployment rate to a four-and-a-half-year low of 4.7 per cent in January, coinciding with signs of higher wage costs, sparked concern over shrinking economic slack and inflation.
Hefty note sales by the US Treasury on Wednesday and rumours concerning private comments made by Greenspan to a US investment bank event helped further shorten rate hike odds.
On top of this, many investors think Bernanke will feel obliged to show he is tough on inflation by raising rates at his first few meetings -- and have history on their side.
"There is no doubt that when I speak to hedge funds and real-money investors, they have some questions. They say that he has to prove his credentials right away," said David Rosenberg, chief north American economist at Merrill Lynch.
Partly, Bernanke must atone for remarks he made in 2002 about dumping money into the US economy by "helicopter" to defeat deflation. Partly, financial markets are just going by what his predecessors did.
"There is a historical pattern that everyone should be aware of because each of the past three newly appointed Fed chairman began their tenure with a quick succession of interest rate hikes," Rosenberg noted.
William Miller, taking the reins from Arthur Burns on March 8, 1978, engineered a 71 basis point rise in the fed funds rate in the first three months of his chairmanship.
Paul Volcker, coming in on August 6, 1979, increased rates by 310 basis points in the same period.
Black Monday
And Alan Greenspan, chairman from August 11, 1987 to January 31, 2006, lifted rates 101 basis points in the first eight weeks before the Black Monday stock market collapse prompted him to ease.
But all three faced much starker inflationary challenges than Bernanke, particularly Miller and Volcker, while Greenspan inherited a weakening dollar which threatened economic stability.
Bernanke takes over an economy that is humming along quite nicely, but could have a problem if the country's housing market reacts badly to further rate hikes.
This is particularly delicate, since the full effect of the Fed's 14 consecutive rate hikes since June 2004 -- a cumulative 350 basis points to 4.50 per cent -- may still be working their way through the real economy, and pushing rates too high now may force a U-turn in 2007.
"Bernanke has to raise interest rates only if certain conditions are in place -- if oil prices are rising and economic indicators strong -- then he has nothing to lose from fears of overdoing it," said Josh Stiles at I.D.E.A.
"I just don't know if that is what the picture will look like by March. It may be much more balanced," he said.
For example, US home builder Toll Brothers Inc cut its sales forecast on Tuesday in a warning the red-hot US housing market may be cooling faster than thought.
And the Fed quarterly survey of senior loan officers on Wednesday found mortgage demand had weakened since October.
A significant turndown in housing might restrain US consumer spending, which has been supported by mortgage refinancing spurred by home price rises, removing an important prop to economic growth.
Fed policymakers expect a slowing housing market to hand off to business investment this year. But some economists warn companies won't risk increasing capacity if they start to have doubts about consumer spending.
"The fairy dust that consumers have been spending from their over-valued houses is floating away," warned Morgan Stanley chief economist Stephen Roach. "If consumers are weak, business are not going to pick up productive capacity," he said during an interview on Bloomberg Television.
However, this is not the prevailing mood of financial markets, even within Roach's own firm.
Morgan Stanley chief US economist Richard Berner sees accelerating job and income growth as a "watershed development" that will underwrite higher interest rates.
"Robust data have eroded market hopes for a quick end to Fed tightening...We believe a 5 per cent funds rate is likely later in the year," he wrote.
- REUTERS
US interest rates could hit 5 per cent
AdvertisementAdvertise with NZME.