Higher Rates: How Far, How Fast?


By Rich Miller Ever since the Federal Reserve cut short-term interest rates to a rock-bottom 1% a year ago, the financial markets have been agonizing over one question: When would the central bank start raising rates again? Well, as June, 2004, draws to a close, investors will finally get their answer. In what has to be one of the most telegraphed monetary-policy changes ever, Federal Reserve Chairman Alan Greenspan and colleagues are widely expected to raise the federal funds rate by a quarter percentage point, to 1.25%, on June 30.

Once that's out of the way, the markets can focus more attention on what are perhaps two even more important questions: How far and how fast is the Fed going to raise rates from here? The answer to those two questions will be critical in determining how the markets and the economy perform over the coming months and years (see BW Cover Story, 7/5/04, "What Keeps Greenspan Up at Night").

ROUGH APPROXIMATION. Fed policymakers have said they want to raise the fed funds rate -- the rate that banks charge each other for overnight money -- to a more neutral, or natural, level. And they've said they intend to do that in a "measured," or gradual, fashion -- a plan they're likely to reaffirm after their two-day policymaking session ends on June 30. But both of those formulations raise more questions than they answer.

What, after all, is a neutral fed funds rate? To try to answer that question, Fed officials first took a look at what the real or inflation-adjusted rate has averaged over time. It turns out that's about 2.5% to 2.75%. Then when you add inflation back in -- excluding volatile food and energy costs, you come up with a neutral fed funds rate rate of 4.25% to 4.5%.

Fed officials admit that's at best a rough, first approximation. (For more on how the central bankers are thinking, see the accompanying Q&As with Fed regional bank Presidents William Poole of St. Louis, Anthony Santomero of Philadelphia, and Tom Hoenig of Kansas City.) Some believe the true neutral rate is below the long-term average, at least temporarily, because of lingering caution among company execs still haunted by the dot-com bust and the corporate scandals of the past few years. Others argue that the neutral rate is above its long-term average, thanks to elevated productivity levels and bigger-than-normal budget deficits. Those factors have increased the demand for credit the past few years.

PASSING PHASE? In the end, central bankers acknowledge that they're unsure what the neutral rate is, adding that much depends on how the economy evolves over time. And that leaves unanswered questions about the pace of the Fed's coming rate increases. With inflation showing signs of picking up, some officials are uncomfortable with the central bank's plan of measured rate hikes and might press it to pick up the pace a bit at the coming meeting.

They're unlikely to succeed, as most policymakers, particularly Greenspan, see the recent rise in inflation as transitory. Already, the spike in energy prices has started to ease as Saudi Arabia has signaled world oil markets that it's increasing production. But the Fed could make clear in its closely followed statement released after the meeting that its plan to raise rates gradually is contingent upon inflation staying contained.

Those who believe the Fed can hike rates in a measured fashion agree on what that doesn't mean. It doesn't mean a repeat of 1994-95, when the Fed upped rates by three percentage points in the space of a year and was blamed for causing economic growth to screech to a halt.

THIS TIME NEXT YEAR. But far less agreement exists over what the plan does mean. For some, it means raising rates at roughly half the pace of 1994/95 -- that is, 1.5 points over 12 months, to avoid unnecessarily crimping growth. That suggests a fed funds rate of about 2.5% by the middle of 2005. For others, it means raising rates at least as fast as the financial markets expect in order to keep inflationary expectations contained. Based on the Chicago futures markets, investors expect the Fed to raise the funds rate to about 3.25% by the middle of next year.

One thing is certain. The widely assumed June 30 hike will put to rest the question of when the tightening cycle will begin. But given how uncertain central bankers themselves are over what comes next, the Fed-obsessed financial markets will still have plenty to chew over in the weeks and months ahead. Miller is senior writer in BusinessWeek's Washington bureau


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