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Extra
Rising rates: How far? How fast?
Even a doubling of the current 1% funds rate is just a start, economists say. Here's how the Fed might handle the long climb back to an inflation-neutral rate near 4%.
By Greg McBride, Bankrate.com
After a period of falling interest rates that prevailed much longer and took rates much lower than expected, the interest rate cycle has clearly changed. This is evident on both long- and short-term interest rates, with mortgage rates beginning to climb in March and three- and six-month CDs inching higher over the past month.
Now that the move to higher rates is under way, how long will the cycle last? How fast will the Federal Open Market Committee raise rates?
The Federal Reserve has clearly communicated its preference to boost rates in a "measured" fashion, almost certainly starting Wednesday as the FOMC meets.
History seems to support this, at least at the outset of interest rate increases. Such was the case with previous campaigns commencing in February 1994 and June 1999, as well as a lone hike enacted in March 1997.
Ready, set, go
This time around will also see the rate-increase festivities kick off with a quarter-point move on Wednesday. This consensus opinion of economists was made more certain by the latest release of the Consumer Price Index on June 15.
After a week of hint-dropping speeches by Fed governors -- each containing references about boosting rates aggressively to keep inflation in check -- the CPI release affirmed that inflation remains in line with expectations.
Although a more aggressive tightening at the June 30 meeting has been rendered unnecessary, any departure from ongoing inflation expectations could accelerate the timing and pace of interest rate hikes later this year.
While odds initially diminished that the Fed would need to implement a half-point hike at any of 2004's upcoming meetings, the message about acting as warranted by inflation has already been floated out there and it is too late to take it back. Inflation will remain in the crosshairs of the Fed's scope and expectations regarding future Fed action will bob up and down with inflation readings in the months to come.
2% is only the beginning
Given the Fed's preference to move interest rates higher in baby steps, it will take four quarter-point moves to get from the current 1% to 2%. Even at 2%, the fed funds rate is certain to remain below the rate of inflation. As a result, a doubling of the fed funds rate is likely just a starting point.
With economists commonly citing a neutral Fed policy as one where the fed funds rate is closer to 3.5 or 4%, this suggests the heaviest Fed lifting will unfold during its eight meetings in 2005.
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If the fed funds rate goes to 2% by the end of 2004, an ongoing, measured campaign of quarter-point increases would put the fed funds rate at 4% by New Year's Day 2006.
Of course, this is purely conjecture at this point and subject to certain alteration as time goes on, particularly if inflation nears a boiling point. In that instance, the Fed would certainly administer a double dose by hiking rates by a half-point, thus accelerating the entire timetable of interest-rate increases.
Many paths to the same goal
Worth mentioning are several factors that could just as easily derail what currently looks to be a sustained, and rather prolonged, change in Fed policy. The economy could suddenly slow because of a terrorist strike, soaring oil prices or an unforeseen impact of rising rates in consumer spending. A sudden slowdown of the Chinese economy could quell China's hunger for Treasury securities that has kept a lid on bond yields and fixed-mortgage rates thus far. Any widespread about-face in foreigners' demand for U.S. securities amid rising budget and trade deficits could lead to a swift dollar decline that would inflate government borrowing costs, erode corporate profit margins and endanger further job growth.
Regardless of how far and how fast interest rates rise -- or don't -- in the next year or two, it is unlikely to unfold in line with current forecasts. Just as the past several years of Fed policy have shown, even though the destination is known in advance, the route is always subject to change.
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