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The Fed Will Make Several More Rate Increases: John M. Berry

The Fed Will Make Several More Rate Increases: John M. Berry

June 21 (Bloomberg) -- Federal Reserve officials see U.S. economic growth continuing at around a 3.5 percent pace into 2006 with inflation pressures strong enough to merit several more increases in the Fed's target for the overnight lending rate.

Gary Stern, president of the Minneapolis Federal Reserve Bank, summed up the thinking of many of his Fed colleagues when he said in a June 20 interview with a Japanese newspaper (Nihon Keizai), ``Right now there's no reason to stop tightening credit.''

That certainly applies to the policy decision that will be made at next week's Federal Open Market Committee meeting. On June 30, the committee undoubtedly will announce that it has raised the lending rate target to 3.25 percent -- the ninth consecutive quarter- percentage-point increase -- and that it still considers monetary policy ``accommodative'' and that it will continue to raise rates ``at a measured pace.''

For two reasons, officials now seem more likely to keep increasing the target in the second half of this year than they did a few months ago.

First, the 200 basis point increase in the target over the past year has had less of a restraining impact on the economy than most Fed officials had expected because long-term rates have gone down rather than up, as they normally do.

Inflation Still Strong

That has kept home mortgage interest rates low, directly boosting home prices and residential construction and indirectly supporting consumption spending by allowing homeowners to extract cash using refinancings or home equity loans.

Low long-term rates also have allowed companies to continue to improve their balance sheets by issuing long-term debt and paying off short-term debt.

Second, inflation pressures -- while still ``contained,'' in the view of Fed Chairman Alan Greenspan and other officials -- are still strong enough to be worrisome. Companies appear to have regained some of their power to pass cost increases on to their customers through higher prices rather than being forced to absorb them through lower profit margins.

And oil prices have kept rising, rather than receding as many Fed officials had anticipated.

Actually, Fed officials have been rather pleased that overall prices have been as well behaved as they have been, given what has happened to energy costs. For instance, there is virtually no evidence of any acceleration in wage increases in the wake of higher inflation related to the rise in oil prices.

Moderate Tightening `Sensible'

``I have been happy that the pass-through to core has been less than we feared, and that the expectations embedded in the yield curve have subsided noticeably,'' Jeffrey Lacker, president of the Richmond Federal Reserve Bank, told reporters on June 20 after a speech to a bankers group in Hot Springs. Virginia.

Nevertheless, like Stern, Lacker said, ``I think a moderate pace of continued tightening is a sensible outlook at this point and that it is too soon to say when we are going to stop.''

While Fed officials didn't expect long-term rates to decline when they started raising their overnight lending rate target from its 1 percent level a year ago, that development hasn't been entirely unwelcome.

For one thing, starting from such a low point, the rate had to be raised a long way to get it up to a so-called neutral level -- the level consistent with an economy operating close to full employment with an acceptably low inflation rate. Raising the target that much always had the potential to cause economic growth to slow.

Housing Stimulus

What seems to have happened instead was that it took the stimulus to the housing sector, and the indirect effect on consumer spending, to put the economic expansion on a solid footing. That has been particularly true since the U.S. trade deficit has widened steadily in recent years and therefore been a drag on growth.

In both 2003 and 2004, residential construction accounted for roughly a half percentage point's worth of GDP growth, which was 3 percent in the first of those years and 4.4 percent in the second. That just about offset the drag from trade in both years.

At the same time, consumer spending accounted for 2.3 percentage points of the 3 percent increase in 2003 GDP, and 2.7 percentage points of the larger rise in last year's GDP. Those numbers could have been noticeably lower without the indirect support from housing.

As this year wears on, Fed officials will be watching all the data, as they always do. They will have to keep a particularly close eye on whether the latest round of oil price increases begins to dampen growth -- as well as adds to inflationary pressures.

Pause at 4 Percent?

Economist Robert V. DiClemente of Citigroup thinks slowing growth outside the U.S. will help keep inflation contained while ``higher energy bills probably will continue to siphon strength from other areas.'' That combination of contained core inflation and slightly slower growth should keep long-term interest rates on 10- year U.S. Treasury notes under 4.5 percent for the remainder of this year, he told his clients.

``With policy makers unlikely to receive much help from higher long-term interest rates, tightening will have to be transmitted through other channels,'' DiClemente said. ``Officials also will have to sort out the level of short rates that is consistent with price stability this cycle.''

His own best guess as to where the Fed will pause in raising rates: 4 percent.

On the other hand, if long-term rates stay as low as DiClemente expects, then the housing sector may not cool off very much in the second half of the year, and Fed officials would be just as happy if whatever price bubble there may be doesn't get any bigger.

Trade Deficit Concerns

That could persuade Fed officials to take another step or two. Besides, the Fed has a history of taking one or two steps too many in its tightening cycles.

Still, while they have a wary eye on housing, Fed officials are just as wary about the trade deficit. With U.S. economic growth likely to outstrip that in virtually every other industrial nation over the coming year, and with a rising target for the overnight lending rate providing some support to the dollar, everyone at the Fed believes the trade deficit is going to keep being a drag on economic growth.

Perhaps that would offset any urge to tighten an extra notch because of housing bubbles.

To contact the writer of this column:
John M. Berry in Washington at [e-mail].


LINK: http://quote.bloomberg.com/apps/news?pid=10000039&refer=columnist_berry&sid=agP8o9C9IXaI