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Thursday October 20, 2005 - 13:49:07 GMT
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No US interest rate increases in 2006?

The Fed will remain nervous over inflation trends in the short term with increased fears that the jump in energy prices seen in September will cause secondary price pressures. There will certainly be the risk of a wider inflation increase over the next few months, although the most likely outcome is that any increase will be measured.

US growth conditions are liable to deteriorate at least to some extent as consumer spending growth falters even though this will be offset by reconstruction work. The Fed would then face a much tougher task in balancing the needs of inflation and growth, especially if core inflation measures remain under control. There could also be political constraints to aggressive tightening, particularly with a new Fed chairman set to take office next year.

There is a very high probability of a further interest rate increase at the beginning of November and there is also at least a 50% chance of a tightening in December. At that point, however, the tightening is likely to be put on hold to assess economic developments. Indeed, there is a good chance that interest rates will not actually be increased during 2006.

Short-term inflation fears

The Federal Reserve has increased US short-term interest rates to 3.75% from a low of 1.0% in 2004 and the debate on where rates will peak will be an important market focus in the short term.

Headline consumer prices rose 1.2% in September with the annual inflation rate pushing to a 15-year high of 4.9%. Producer prices also rose sharply with a 1.9% monthly increase for September, the biggest monthly increase for 20 years.

Core inflation indicators have remained under control with the underlying consumer price index increase held to 0.1% for September while the core PPI increase for the month was 0.3%. The core annual CPI increase fell to 2.0% from 2.2% and the Fedís preferred measures of inflation has held below 2.0% over the past few months. The low level of core inflation will offer near-term relief for the Federal Reserve, but the central bank will need to remain on high alert in the short term. Although the immediate evidence has been encouraging, there will still fears that the jump in energy and raw material costs will gradually feed through into wider inflationary pressure over the next few months. In this context, there will be some concerns over the Fedís Beige Book which reported that companies were having some success in pushing price increases on to customers.

The Federal Reserve has increased interest rates at the last 11 consecutive FOMC meetings and there is a strong probability that the central bank will tighten again at the beginning of November. Futures markets are looking for another rate increase in December and have priced in a further increase to 4.25% while there are market expectations that rates will increase to 5.0% or higher during the course of 2006.

Growth could be at risk

The Federal Reserve, however, has a dual mandate of maintaining price stability and the highest possible level of employment. The Fed will, therefore, be placed in a very difficult situation if there is a rise in underlying inflation at the same time as a deteriorating economy as there will be conflicting pressures on the Fed.

The labour market remained strong in the third quarter and the unemployment level is low at 5.1% which will support near-term optimism. The growth outlook will remain very important in the short term and there is likely to be unease over consumer spending levels, especially as the savings rate is already at a very low level. In this environment, any negative income shock will quickly result in lower spending growth.

Retail sales rose 0.2% in September and there was an underlying increase of 1.1% excluding auto sales, but spending was artificially inflated by the sharp rise in gasoline prices. Consumer confidence levels have continued to deteriorate over the past few weeks with little evidence of a recovery from the hurricane Katrina shock. Consumer confidence levels do not have a strong predictive track record for consumer spending trends, but there will still be concern over underlying conditions, especially if high energy prices are sustained. There will be a drop in real disposable household income which will undermine the spending outlook.

In this context, the housing sector will remain very important for the US economy and interest rates over the next few months. If prices hold firm, there will be a much reduced risk of a drop in household spending. Conversely, any drop in prices would increase the threat to consumer spending. Overall, the risks to consumer spending will tend to increase, especially as rising long-term interest rates will push up mortgage rates. Monetary policy also acts with a lag and the full impact of the tightening already sanctioned will not be felt until next year. Also, the evidence of underlying inflation will not be resolved for the next few months, increasing the risk of policy mistakes next year.

The economy will receive a boost from re-construction following the hurricanes this year. Overall, however, there are likely to be significant constraints on Fed tightening from early in 2006.

Fed uncertainty will increase

Additional uncertainty over Fed policy is likely to be created early in 2006 by the departure of chairman Greenspan after 18 years in charge. The Bush administration has not yet nominated a successor to Greenspan and, whoever is nominated, there is likely to be slightly more caution over policy in the short term. Bush has pledged a non-political appointment, but the new chairman is still likely to be more reluctant to sanction further rate increases.

Although difficult to estimate, a neutral level for monetary policy is likely to be when short-term interest rates are within a 3.5-5.5% range and the Fed will probably prefer to keep rates in the lower half of the projected band given the underlying stresses within the economy. There is, therefore, likely to be caution in pushing rates above 4.5%.

 

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