Financial Times : Fed insists that the only way for rates is up

Fed insists that the only way for rates is up
By Philip Coggan
Financial Times

Investors should not be in any doubt. US interest rates are heading steadily upwards this year. The minutes of the latest US Federal Reserve meeting, released this week, made that perfectly clear.

At the start of 2004, some economists still believed the US could get through the year without a tightening in monetary policy. In the event, the Fed started raising rates in June and pushed through five quarter point increases over the course of the year. If the Fed were to tighten by a quarter at every meeting in 2005, short rates would be more than 4 per cent by the end of the year.

This steady pace reflects the unusual levels to which rates fell after the bursting of the dotcom bubble, the terrorist attacks of September 11 2001 and the corporate scandals of 2002. The Fed appeared to face a deflationary threat and thus cut rates to crisis levels of 1 per cent. It was slow to move them back up because of its fear of repeating the mistakes made by the Bank of Japan in the 1990s. Once deflation sets in, it can be very hard to reverse, not least because nominal interest rates cannot be cut below zero.

By the middle of last year, it seemed as if the US economy was strong enough to take the strain. Consensus forecasts suggest that US gross domestic product will have grown by 4.4 per cent in 2004. US monetary policy was starting to look far too loose.

The problem for the markets is that rates started from such a low point. There is thus a long way to go before the normal or "neutral" level is reached. And the Fed is unwilling to risk shocking the markets with a couple of big moves of, say, a percentage point. Investors are thus forced to suffer the Chinese water torture of regular small increases.

At what level will rates stop rising? One rough guess is that nominal rates should be around the same level as the trend growth rate of nominal GDP. For the US, that would be around 3.5 per cent.

Another approach is to say that rates should be modestly positive, after inflation. Here, however, the problem is that there are so many different inflation measures. The official US consumer price index was 3.5 per cent higher in November than a year previously. That leaves real rates looking sharply negative. But core inflation, excluding fuel and food, is only 2 per cent. If the latter measure is acceptable, then rates should be at around a neutral level in the range of 3 per cent to 4 per cent.

In the light of history, rates of 3 per cent to 4 per cent would hardly be alarming. After all, short rates were 6.5 per cent as recently as December 2000.

Nevertheless, the adjustment period could be painful. When the cost of financing is low, the temptation to speculate is high. This has been exacerbated by the decline in the dollar. When rates were 1 per cent, investors borrowing in dollars and investing in assets denominated in another currency found that their cost of financing was zero or even negative. The Fed minutes noted that low rates were encouraging "potentially excessive risk-taking in financial markets".

Such risk-taking may be showing up in the low levels of corporate and emerging market bond spreads, or in the speculative surges seen in some commodity prices last year. It may also have encouraged banks to devote more of their capital on trading, an often lucrative but unreliable source of profits.

So far, the adverse effects of higher interest rates have not shown up in the US economy. The housing market was very strong in 2004. Most US homebuyers have fixed mortgage rates and those are set with reference to Treasury bond yields, which, at the longer end, are around the same levels as a year ago.

The bond market was "the dog that didn't bark" in 2004. Traditionally, when short rates rise substantially, long rates move higher as well. Perhaps investors are still relaxed about inflation and relieved that the Fed is taking action. Or perhaps Treasury bond yields are being kept artificially low by buying from Asian central banks.

Either way, one has to wonder whether the dog can stay silent this year if the Fed keeps raising rates. A rate rise every meeting would leave the Fed funds rate equal to the current 10-year Treasury bond yield by the end of the year.

It is not out of the question for short rates to be equal to, or higher than, long rates. But such inverted yield curves tend to occur after inflationary busts, when central banks have been forced to push short rates temporarily high to squeeze the economy.

No such conditions are being forecast for 2005. The consensus prediction for US GDP growth this year is 3.5 per cent, around the trend rate, and consumer prices are expected to rise by only 2.3 per cent.

Something must surely give. Either the economy will have to slow sharply, justifying current long bond yields, or those bond yields will have to rise. The danger is that they might have to rise quite sharply. Another rule of thumb is that the long-term bond yield should be equal to the trend rate of nominal GDP. If one assumes an inflation rate of 2 per cent, that means 10 year bond yields could rise to 5.5 per cent from the current 4.3 per cent.

US equities, which still look overvalued, may struggle either way. A weaker economy would hit earnings while higher bond yields might prompt switching into fixed income.

Then there is the impact on the dollar. In the past few days, it looks as if the dollar's decline against the euro may have come to at least a temporary halt. The last Fed funds increase took US short rates above those in the eurozone. It seems highly unlikely that the European Central Bank will raise rates soon. So the yield attractions of the dollar should grow over the coming year.

For the time being, it also looks as if investors have switched their attention from the US trade deficit to the superior growth rate of the US economy relative to the eurozone. That may allow the dollar to rally in the short term, although the long-term prospects for the US currency do not look bright.

philip.coggan@ft.com