Has the Fed Finished Tightening?


By David Wyss After tightening for the 13th time (appropriately on Dec. 13), the Federal Reserve appears to be signaling that it's nearing the end of the rising-rate cycle. Standard & Poor's expects another 25-basis point hike at the Jan. 31 meeting, and another 25 basis points in March, if economic growth remains strong. We then expect the Fed to close up shop for the rest of 2006.

The wording of the Fed statement changed significantly. The phrase "policy accommodation" was removed, suggesting the Fed believes that rates are no longer accommodative. It did, however, suggest at least one more hike by saying that "further measured policy firming is likely to be needed." The Fed has taken its foot off the gas pedal and now will decide how hard and often to hit the brakes.

The European Central Bank raised its target rate to 2.25%, from 2%, on Dec. 1, as ECB President Jean-Claude Trichet had already signaled. The ECB seems to have adopted the Fed strategy of telegraphing moves well in advance so as not to surprise the market. The ECB was careful to say this wasn't the start of a Greenspan-style string of rate hikes. It will probably not move at its next meeting, but we expect the ECB to hike rates two more times by mid-2006.

FOREIGN EXCHANGE. It isn't clear to us that such hikes are needed, given Europe's still-dismal growth and low core inflation. The ECB expects growth prospects to improve next year, however, and is worried about the weakness of the euro and outflow of capital from the eurozone. The housing bubble in most of Europe may also be a concern for the ECB, since eurozone housing prices (with the notable exception of Germany) are up even more than in the U.S.

Foreign capital is still flowing into the U.S., holding down bond yields and supporting the dollar. It's hard to see this reversing until the Fed stops tightening. We expect both U.S. and European bond yields to rise next year and the dollar to come down moderately starting in the spring, after the Fed ends its tightening cycle.

In October, private foreign investors sent a net $97.3 billion to the U.S., while foreign central banks moved $13 billion here. Most of the private money and all the official funds went into Treasury and agency bonds -- only $10.4 billion of the funds went into the equity market. The European and Japanese appetite for fixed-dollar assets is keeping bond yields low. The question is, will that appetite remain if the dollar drops and investors get paid back in devalued dollars?

SEASONAL DROP. If foreigners begin to exit the U.S. bond market, long-term interest rates will climb more sharply. Could these rate hikes finally burst the housing bubble? The declines in housing starts and existing-home sales have already created fears that the bubble has sprung a leak. The reports of the end of the bubble may prove premature, however, as October's sharp jump in new-home sales indicated. This is a difficult time of year to judge housing. The seasonal factors coming off the summer buying and building season are enormous. Most families buy homes during the summer, when school is out of session.

The press has made much of the drop in home prices in recent months, but this is normal seasonal behavior. Median home prices dropped in the fourth quarter last year as well. Home prices almost always jump in the second quarter and weaken in the fourth. The year-on-year increase in the median existing home price is at a record high. However, we do expect appreciation to slow in 2006.

CONFLICTING SIGNALS. There has been a drop in the median new home price over the last three months, which may be more meaningful. The weakness that we're seeing seems concentrated in high-end homes -- which we had expected in a period of rising interest rates. Mortgage rates are rising, so it's expensive to trade up. But with rates still far below their historical average, first-time homebuyers continue trying to get in before they rise further. The result is a shift in the mix of home sales toward smaller homes.

Our belief is that the market is topping out, and that home prices will stabilize rather than drop precipitously. However, the signs are still pointing in both directions. That's a change from recent years, when all the signs were pointing up. Our best judgment is that housing bubble may deflate slightly, as evidenced by a topping out in prices and slowed appreciation next year, but that it hasn't -- and isn't about to -- burst.

Wyss is chief economist for Standard & Poor's


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