Will Fed Have to Raise Interest Rates Soon?


A few Federal Reserve policy-makers have begun talking openly about the need to raise interest rates, but it appears more likely the U.S. central bank will stay on hold until early 2009.

Inflation-wary hawks have stressed in recent speeches the need to remove the central bank's muscular policy easing, which has seen it slash the benchmark overnight federal funds rate by 3.25 percentage points to 2 percent since mid-September.

At the same time, Fed officials who had been more dovish and worried about growth have also been talking. Their message is that the current level of rates remains appropriate.

The remarks, together with better-than-expected economic data, have financial futures markets seeing a 46 percent chance of a quarter point rate hike at the bank's meeting at the end of October and a 64 percent chance of an increase by year end.

But Fed watchers say the betting is premature.

"We expect a long hold ...until March 2009, when they start hiking," said Brian Sack, a former senior economist at the Fed Board and now with Macroeconomic Advisers. "My sense is that they are in watch and wait mode."

"There is a lot of discussion of inflation risks, but I am skeptical that they are at a turning point," he added.

Rising prices for fuel and food have hurt American pocketbooks even as the slowdown in the U.S. housing market crimps economic growth and lending conditions remain tight.

Probably the best reason to expect the U.S. central bank to stay on hold for a prolonged stretch is Fed Chairman Ben Bernanke, who continues to worry about fragile credit market conditions.

Bernanke said last week that markets were healing but remained "far from normal" and "moribund." "He is emphasizing that it is going to take a while for credit conditions to improve.

So, implicitly, we can read that as saying that he likely doesn't see policy tightening for some time," said Sack.

Investor eagerness to anticipate the resumption of rate hikes also replays market missteps during previous policy-easing campaigns, said economists at Citigroup.

"The pattern in forward markets is not unlike previous easing cycle endpoints in 1992 and 2003 when investors prematurely anticipated rising rates and ultimately had to throttle back as evidence of a sustainable recovery lagged," they wrote in a note to clients Friday.

Bernanke and his number two, Donald Kohn, have used speeches to signal changes in the Fed's stance as it battled the housing crisis and credit crunch.

Their guidance has been essential because the Fed has been clearly split between hawks concerned about inflation and other policy-makers fearful the fallout from the housing crisis could tip the economy into a prolonged and painful recession.

The two camps are back in the spotlight.

Kansas City Federal Reserve Bank President Thomas Hoenig and Dallas Fed President Richard Fisher both voiced worry over inflation in recent speeches, with Hoenig talking about taking back the rate cuts at some stage. Fisher, together with Philadelphia Fed President Charles Plosser, voted against the last rate cut.

San Francisco Fed chief Janet Yellen, who has been among the officials sounding the most worried about growth, also stressed the risks of inflation.

But she said it was premature to start talking about when to raise rates.

Her balanced assessment was echoed by Atlanta Fed President Dennis Lockhart and Charles Evans of the Chicago Fed.

"All of this uncertainty and diversity of opinion probably puts the fed funds rate at a 2 percent floor at this juncture," said Lynn Reaser, chief economist at Bank of America Capital Management in Boston.

The Fed lowered rates by a quarter point to 2 percent at its last meeting at the end of April but removed an explicit bias to continue easing.

Markets took that as a sign it was pausing the rate cut campaign to give its earlier reductions a chance to work, while giving a nod to inflation concerns amid soaring energy and food prices.

That impression has hardened after a series of economic releases that came in a bit better than expected -- or at least no worse -- and after no policy-maker tried to suggest an alterative reading of the statement.

"All policy-makers believe that a 2 percent funds rate is not a level that can be sustained with the objective of keeping inflation in check ...

it is more a question of the timing of the tightening," said Reaser, who looks for a hike in 2009.