Fed won't hit the pause button

[notiCIas]

Fed won't hit the pause button

Strong job report makes it much less likely the Fed will stop raising rates anytime soon.

May 6, 2005: 11:35 AM EDT
By Paul R. La Monica, CNN/Money senior writer


NEW YORK (CNN/Money) – Slowdown? What slowdown?

The April job report was much better than most economists were expecting -- and strength was across the board. Payroll growth surged, hourly wages came in above Wall Street forecasts and the work week grew as well.

The good news: the numbers help soothe fears that the economy was heading into a slump.

But the bad news is that if the job market keeps going at its recent pace, that could fuel a pickup in inflation -- and a more aggressive Fed. Many economists have been saying that rising oil prices weren't that much of a worry as long as the labor market, and wage growth, remain contained.

That may now start to change.

"Growth is picking up in the labor market. People are returning to work, working longer hours and making more money. This shows that the economy is healthy," said Drew Matus, senior economist with Lehman Brothers. "Fears of a soft patch were overblown."

Those fears started boiling after last week's news that the economy grew at the slowest pace in two years in the first quarter.

So what's next for the job market, and what does that mean for the Fed?

Return of inflation fears?
The classic telltale sign of inflation comes when more people are employed, and have more money to spend. So the job report means Wall Street's hopes that the Federal Reserve will soon pause in raising interest rates are probably kaput.

"The only dark cloud to this number is that now the Fed has no reason whatsoever to stop raising rates," said Barry Ritholtz, chief market strategist with Maxim Group, a New York-based money management firm.

The Treasury bond market reacted accordingly. Bond prices sank, sending the yield on the benchmark 10-year Treasury up to 4.26 percent, from 4.16 percent Thursday, as investors bet rates would keep heading higher still. Bond prices and yields move in opposite directions.

Bond yields and other rates typically rise when the economy is strong and fall during periods of sluggishness.

Several economists said the April job report is a sign that the first-quarter soft patch may have been a blip induced largely by record high oil prices. And with oil prices falling in recent weeks, that's a good sign for the economy.

"The Fed has assumed that the weakness in the first quarter was temporary. This confirms that," said Steven Wieting, senior economist with Citigroup Global Markets. "The reasonable view was you don't have a one-third rise in energy prices without consequences."

'Measured' for 'measure' in rate hikes
With that in mind, both short-term and long-term rates are likely to keep creeping higher, said Craig Coats, co-head of fixed income at Keefe, Bruyette & Woods, a New York-based investment bank.

The Fed raised its short-term rate target a quarter-point for the eighth straight time Tuesday and kept its pledge that future increases would come at a "measured" pace. Despite the Fed keeping that language, some investors were betting the Fed would pause soon due to the slowing economy.

But Coats thinks quarter-point hikes at the Fed's next meetings in late June and early August are now a given. That would bring the fed funds rate, a short-term bank lending rate controlled by the Fed, up to 3.5 percent.

And unless fresh numbers hint at a drastically slowing economy in coming months, Coats said the Fed is likely to keep raising rates after that.

"If the data stays like this, the Fed probably keeps going to 4 percent," he added.

But Maxim's Ritholtz said it would be premature for investors to start worrying about the Fed having to get more aggressive. The central bank won't consider raising rates by a half a point until there was firm evidence the labor market is really back on track.

"This is a solid number but any single data point does not make a trend," he said. "So far, the strong points have been the outliers. We would need to see three strong numbers in a row."

In other words, it looks like investors have every reason to take the Fed at its word. Despite a lot of volatility in the markets lately, when all is said and done, the economy still appears to be on steady ground. So there is no rational reason for the Fed to pause, which could be a sign it thinks the economy is in trouble.

"It's important to note that weaker-than-expected is not the same thing as weak, said Lehman's Matus. "For an economy of our size to be growing at 3 percent is quite impressive. The Fed is likely to keep moving rates higher at a measured pace."