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Thursday February 3, 2005 - 14:36:27 GMT

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How high can US rates go?

The most likely outcome is that the Fed will continue to increase rates gradually over the next three meetings, with rates pushed to 3.25% by the end of June to keep inflationary pressure under control. Over the second half of the year, although rates will still be relatively low in historic terms, the Fed may have to consider a pause in the tightening at around 3.5%, especially as the high debt burden could start to slow the economy sharply. If, however, bond yields fail to increase and spending remains strong, short-term rates may have to be pushed to above 4% and possibly as far as 4.5% over the second half which could then trigger a sharp economic slowdown. There will also be a risk of divisions within the Fed and Greenspan’s authority may start to fade in his final year as Chairman.

FOMC increases rates again

The US Federal Reserve increased interest rates again on February 2nd with the Fed funds rate pushed to 2.5% from 2.25%, the sixth increase since July 2004 from the historic low of 1.0%.

Inflation risks increase

There is greater concern over inflationary pressure within the Fed even though consumer price trends have remained under control. Headline consumer prices fell 0.1% in December and the underlying inflation rate was held to 2.2% for 2004 as a whole. The Fed will not be overly concerned over the weak dollar, especially as there has been a rally since the end of 2004. The US authorities will still want to avoid inflation expectations taking hold, especially with oil prices still close to US$50 p/b. The slowdown in domestic productivity growth and increase in medical costs will increase the risk that businesses will attempt to maintain profit levels through higher prices. In this context, there will be some concern that companies are regaining pricing power as inflationary pressure could quickly build.

High debt should curb rate hikes

US consumers are still running very high debt levels and low interest rates have been vital in sustaining the housing market. Figures for the third quarter of 2004 recorded that US personal debt had risen to 116% of disposable income. This remains a very high level in historic terms and there will be concerns over a rapid adjustment in personal balance sheets. The immediate risks have been reduced by the high level of property prices and debt is only just over 20% of household net worth. The figures will, however, become a lot more alarming if there is a significant drop in house prices or the employment market starts to weaken again.

The consumer sector will also have a greater sensitivity to interest rate rises given high debt and the Fed will also be wary of raising rates too fast as this could destabilise the economy. Budget concerns will be significant as rising interest rates will increase US Treasury interest payments. This will not be a major short-term focus, although it should ensure that the Fed will want to avoid policy shocks. In this context, long-term interest rates will also be very important given the linkage of debt and mortgage payments to long-term interest rates.

Bond yields fail to rise

One of the major market puzzles over the past few months has been the low level of bond yields. Despite higher short-term rates, rising oil prices, strong growth, a weak dollar and inflation concerns, bond yields have actually fallen since the Fed started to tighten with rates now around 4.2% while the yield curve has flattened significantly. There has been support from Asian central bank buying, but the market behaviour is still a surprise. The market trends do not suggest serious concerns over inflation. Alternatively, markets may be expecting a Fed tightening to quickly dampen consumer spending and slow the economy. In this context, the Fed may have done too good a job in reassuring markets over inflation. Low long-term yields will, however, keep mortgage rates low and will also help prolong consumer spending growth. This will actually increase the risk that short-term rates have to be pushed higher. If this is the case, there will be the risk of a more rapid market adjustment in the second half of 2005.

Rates are still low

In historic terms, the level of US interest rates is still low. Real rates are only just positive compared with a ‘normal level’ of 1.5-2.0% and this suggests that rates would not reach a neutral level until an increase to at least 3.5%. A neutral rate is where monetary policy is not providing any stimulus or restraint to the economy.


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