April 20, 2004

Economic stars in alignment for the Fed to increase rates

By James W. Coons

The tip-toe of oncoming interest rate increases has turned to thundering footsteps. Brace yourself. The Federal Reserve is preparing to raise short-term interest rates this summer, despite the November election. The initial increases will be small, but the eventual peak in rates will be higher than anticipated.

Quite uncharacteristically, Fed officials have spelled out the preconditions for raising rates. In general terms, they want clear signs that deflation is not a risk and that the economy will keep growing. Specifically, they are waiting for inflation to stop falling and start rising and for a string of large monthly increases in employment.

Both of those preconditions are close to being met.

The Fed’s key inflation measure fell to 0.4% during the three months ending last September. It has increased to 1.6% in the most recent three-month period. The economy has backed away from the deflationary cliff, and if leading indicators are on target, inflation will continue to move higher.

Secondly, the long-awaited economic rebound has arrived. Growth reached 6% annualized in the second half of last year and has continued at a nice clip this year. Exports and investment in equipment each grew 15% annualized in the second half, and pre-tax corporate profits grew 50% annualized.

But the clincher is the 308,000 increase in employment during March, which capped an impressive nine-month revival in labor markets. Additional job gains are necessary to lock in the second precondition for rising rates, but leading indicators are encouraging. Prominent among them, the Manpower Inc. survey found hiring intentions for this quarter to be the highest since before the 2001 recession.

The past offers some guidance about the timing of the first rate increase.

Following the 1990-91 recession, the Fed waited 518 days after the last reduction in rates before increasing them the first time. The last reduction for this cycle occurred on June 25, 2003. A 518-day lag would put the first increase on November 24. The Fed only changes rates at scheduled meetings, except in emergencies. The closest meeting date is November 10 – uncomfortably close to the general election on November 2.

Another precedent was the 1995 near-recession, when rates stayed down for 419 days. The meeting scheduled for August 10 will be 412 days after the most recent rate reduction. These comparables are instructive, but there is no magic to how long rates are held flat.

The inflation-adjusted federal funds rate, otherwise known as the real funds rate, is a more meaningful gauge because it is a true barometer of borrowing costs. Following the 1990-91 recession the Fed started raising rates two years and one month after cutting the real funds rate below one half percent. The real funds rate pierced that mark in this cycle two and a half years ago, so by this measure the first increase is already overdue.

But the most important factor is employment growth. In the last cycle, the Fed waited eleven months after the first monthly jobs gain in excess of 200,000 before raising rates. Since the March employment increase was the first above 200,000 for this cycle, the eleven-month lag translates into a first move next February.

The election probably will not play a major role. Policy makers would prefer to be inactive during the period surrounding an election to avoid involvement in politics. That would rule out a move at the September or November meetings. (There is no meeting in October.) Yet the Greenspan Fed raised a key interest rate on Labor Day weekend in 1988, when Vice President Bush was running for his first term. The lesson is: if the Fed cannot avoid acting around an election, it will act.

This unofficial election blackout will not matter because there is ample time to prepare markets for a move at the August 10 meeting. The rate-setting committee meets next on May 4, at which time it is likely to shift its official stance from leaning toward lowering rates to neutral. At the June 30 meeting, it can lean toward raising rates. Greenspan will testify on monetary policy before the House and Senate in July, at which time he can telegraph an increase at the August 10 meeting. By then four more months of reassuring employment gains will be available.

Ready or not, here it comes.

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