Next Stop, Higher Rates? Not So Fast


By Rich Miller When the economy started weakening a bit over a year ago, the Federal Reserve Board sprang into action. Greenspan & Co. cut interest rates early and often -- 11 times to be exact -- in a bid to stave off the downturn. Soon, Wall Street analysts dubbed the central bank's aggressive approach as "just-in-time" monetary policy.

Now the economy is showing signs of recovery. On Jan. 30, the government reported that gross domestic product unexpectedly edged up 0.2% in the fourth quarter. So some investors are beginning to fret that the Fed will be nearly as aggressive in ratcheting rates back up as it was in cutting them.

Futures markets sure seem to think so. Even though the Fed's Open Market Committee held rates steady on Jan. 30 after a year of cutting, the betting in futures pricing seems to be that the Fed could start tightening credit as early as the second quarter and may boost rates by more than 1.5 percentage points this year.

LATER AND MODEST. Are the futures markets right? Probably not. The watchwords for the Fed for much of 2002 are likely to be "just hold on," not "just in time." Sure, it could start nudging short-term rates higher later this year. After all, they're now at 40-year lows after the Fed lopped them by an unprecedented 4.75 percentage points in 2001. Any increase is likely to come later and be much more modest than the futures markets imply.

Greenspan & Co. is hopeful that inflation will continue to ebb and that productivity will pick up as the economic picture brightens. At the same time, policymakers are worried that the recovery will lack oomph and won't be nearly as rapid as many Wall Street investors are betting on, leaving the stock market vulnerable to a further sell-off. "There's a good chance that the economy may be at least a little softer than the consensus [expects] over the next year or so," Richmond Fed President J. Alfred Broaddus told a business group on Jan. 17.

The economy will doubtless get a lift in the short run as companies stop running down their inventories and start rebuilding stocks. In the fourth quarter alone, Corporate America slashed inventories at an annual rate of $120 billion, slicing some 2.25 percentage points off GDP. Once the stock shelves are clear, the economy will get a boost, perhaps as soon as the first quarter.

WHAT GROWTH ENGINE? "It seems to me pretty clear that the first quarter will be a positive quarter, some multiple of what the fourth-quarter number is," Treasury Secretary Paul H. O'Neill told reporters after the release of the better-than-expected fourth-quarter GDP numbers. Fed officials agree, with some looking for an annual growth rate of 1% to 2% in the current quarter.

However, they're hard-pressed to find much of a growth engine outside of pared inventories. The housing market has stayed strong throughout the downturn, so there's little, if any, room for it to move higher this year. The same can be said for consumer spending. Indeed, many analysts expect consumer outlays to tail off in the first quarter after zooming ahead at the end of last year in response to 0% financing offers from the nation's carmakers. And with the rest of the world still struggling to come out of recession, a pick-up in U.S. exports isn't too likely.

That leaves business investment. Companies spent much of last year hacking away at their capital spending budgets as they struggled with shrinking profits and sinking demand. Although signs are that the worst may be over -- capital goods orders have risen for three straight months -- central bankers don't expect a big rise in investment anytime soon, especially with corporate profits still pinched.

INFLATION? NO PROBLEM. In fact, Fed policymakers worry that investors may have gotten too far ahead of themselves in betting on a rapid earnings rebound. If Wall Street's expectations prove too lofty, as many on the board fear, the stock market could be in for some tough times ahead. That would act as a damper on the economy by undermining consumer confidence, giving the Fed another reason not to be too quick on the draw with rate hikes.

Also, with the recovery likely to be modest, inflation should stay well under control. Some Fed policymakers even see inflation ebbing further this year as the economy recovers. If they're right, real, or inflation-adjusted, interest rates will rise this year, again giving the Fed less reason to take action in the near term.

Productivity is the Fed's other ace. It has held up remarkably well during the recession. The GDP numbers imply that productivity growth was surprisingly strong in the fourth quarter. Fears that output would take a big hit post-September 11 appear to have been misplaced. If anything, things should get even better as the recovery gathers steam. "The long-run picture remains bright," was how Greenspan put it in a speech on Jan. 11.

With Fed officials still firm believers in the promise of the New Economy, caution will more than likely be their mantra this year. That means giving growth a chance -- and holding off on higher rates until a recovery is clearly under way later this year. That should be a comfort to investors and borrowers alike. Miller covers the Federal Reserve for BusinessWeek in Washington


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