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Thursday June 16, 2005 - 13:41:40 GMT
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How far will US interest rates rise

The US Federal Reserve is virtually certain to increase interest rates by another 0.25% at the end of June and there is at least a 50% chance of a further increase in August. This would take the Fed Funds rate to 3.5% and put short-term rates at the lower end of a neutral range.

The US growth rate is liable to slow over the second half of the year as consumer spending slows. The latest indicators suggest that inflation should remain under reasonable control. Although there will be some concern over a fresh rise in energy costs, the overall indicators suggest that the Fed will not need to take aggressive action to curb inflation.

Monetary policy acts with a delay and the full impact of rate increases already sanctioned will not be seen until next year. The bond market will promote uncertainty, but there is a good chance that the Fed will decide to pause the tightening process during the third quarter, especially as Fed Chairman Greenspan will not want to risk a very sharp slowdown in the US economy.

Uncertainty over Fed intentions

The US Federal Reserve has increased US interest rates at the last eight successive FOMC meetings with the Fed funds rate increased to 3.0% from a record low of 1.0%. As rates approach a more neutral level, there will be increased speculation over how far rates can rise, and whether the Fed will pause, or whether it will continue the tightening process and pursue a restrictive policy.

The speculation has been fuelled in part by recent comments from Regional Fed Governor Fisher who hinted that the Fed could consider a pause in tightening after one further increase. Former Fed official Blinder, however, stated that he would be surprised if there was a pause in the tightening process below a rate of 4.0%. Fed Chairman Greenspan, in his latest comments, suggested that a measured monetary tightening would continue in the short term, but he gave no hints as to where a likely peak in rates would be.

Inflation under control

The latest US inflation data has painted a mixed picture, but has not been alarming. The May consumer inflation figures were moderate with a headline 0.1% drop in the index as energy prices declined. The producer price index recorded a steeper 0.6% decline, again due to the drop in energy costs. Oil prices have rebounded in June, pushing back to US$55 p/b and this will tend to put upward pressure back on prices for the June inflation figures reported during July. PMI inflation indicators have moderated slightly and the latest Beige book from the Fed reported that companies were finding it difficult to pass on cost increases. Core consumer prices rose 2.2% in the year to May, unchanged from the previous month. The overall evidence suggests that the Fed needs to remain on alert, but that inflation is under reasonable control.

Mixed growth indicators.

The latest US growth indicators have been mixed with the manufacturing sector showing some sign of deterioration with the ISM manufacturing sector weakening to a two-year low. Officially, however, industrial production recorded an improvement in May with a 0.4% monthly increase. There was also a 0.5% drop in retail sales for May, although this followed a 1.5% increase the previous month. Jobless claims have remained at a relatively steady rate around 330,000, but there was a sharp slowdown in payroll growth for May. Overall, the US economy is still registering steady growth, potentially at around 3.0%.

Yields offer housing support.

The housing sector dynamics will be very important for US growth. Although 10-year yields have bounced back above 4.0%, the low level of longer-term yields has allowed continued mortgage refinancing and this will provide near-term support to consumer spending. There are, however, considerable underlying balance sheet stresses with a very low savings rate and the monetary tightening will start to undermine growth. Any sharp rise in bond yields could result in a sudden and substantial downturn in consumer spending.

Inverted yield curve?

10-year bond yields have risen over the last week, but are still relatively close to the 4.0% level and are lower than when the Fed started the tightening process. There are considerable uncertainties over the bond-market dynamics and the Federal Reserve will be concerned that further significant short-term interest rate increases could invert the yield curve. An inversion could cause serious stresses in the financial sector and this may discourage the Fed from pushing short-term rates significantly higher. The bond-market uncertainties will certainly complicate the Fedís task and suggests that there will caution over further substantial rate increases.

Rates near a neutral rate

The Federal Reserve is likely to become increasingly cautious over the second half of 2005 as monetary policy is more neutral. It is difficult to judge where the neutral rate for short-term interest rates is but, given an inflation rate around 2.0%, it is generally considered to be in the range of 3.0-5.0% and possibly in a 3.5-4.5% band. Given the weak US balance sheets, a neutral rate in the short term is more likely to be in the lower half of this range.

There is of course no guarantee that the tightening will stop when interest rates hit a neutral level. If inflation becomes a greater problem, the Fed would have to consider a shift to a tightening bias, although the net risks suggest that the Fed is more likely to err on the side of keeping rates low.

Stronger dollar helps

The firmer US dollar in global markets will have a small impact in curbing inflationary pressure and the US currency rally has also tightened monetary conditions. A substantial impact is likely, but a sustained US currency rally would make it easier for the Federal Reserve to sanction a pause in the tightening process.

 

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