Measure for measure

[notiCIas]

Measure for measure

The Fed should raise another quarter-point this time. But are more aggressive hikes in the cards?

February 1, 2005: 10:39 AM EST
By Paul R. La Monica, CNN/NMoney senior writer


NEW YORK (CNN/Money) - Wall Street thinks the chances of the Fed not raising interest rates again Wednesday are about as great as the Pittsburgh Steelers winning Super Bowl XXXIX.

What's that, you say? The Pittsburgh Steelers aren't in the Super Bowl? Exactly.

According to the Chicago Board of Trade's fed funds futures contract, traders believe there is a 100 percent chance the Federal Reserve will boost short-term rates another quarter percentage point, to 2.5 percent, on Wednesday. That would mark the sixth such increase since June of last year.

But there is a tiny amount of suspense surrounding the meeting. A few investors are betting on a bigger, half-point increase in the central bank's target for its fed funds rate, an overnight bank lending rate.

Could the Fed surprise Wall Street and raise rates more aggressively than expected?

The minutes of the Fed's last meeting in December showed that some members were starting to express more worries about inflationary pressures, including rising energy prices and the weak dollar. The fear is that a jump in inflation would put a dent in economic expansion.

But two key reports released last Friday may ease some of these qualms, at least a bit.

The government reported that gross domestic product growth grew at a slower-than-expected 3.1 percent rate in the fourth quarter, despite a big increase in personal consumption expenditures, excluding food and energy costs, a widely watched measure of inflation.

Economists said the primary culprit for the weaker GDP growth was a drop in exports and a surge in imports.

But employment costs also grew at a surprisingly slow rate in the fourth quarter, with wage growth up just 0.4 percent, according to a separate Labor Department report. All that points to a more muted inflation picture.

"There won't be any change in the script the Fed has laid out," said Mark Zandi, chief economist with Economy.com. "Export growth has weakened and there is a lid on wage growth. This data takes some pressure off of the more hawkish Fed members."

Sticking with a "measured" pace?
So most Fed watchers think that not only is a half-point rate hike not in the cards, it would also be a big mistake. For one, it would mark a major departure from the central bank's series of quarter-point hikes.

"Raising rates by more than 25 basis points would shock the market so much that the Fed's credibility would vanish," said Jack Ablin, chief investment officer with Harris Private Bank. There are 100 basis points in one percentage point.

The Fed has painstakingly telegraphed its moves on rates for the past year. So investors will be paying close attention to the statement that accompanies the rate decision. If the Fed reiterates its "measured" stance toward raising rates, as it has since May, that would be a sign that no bigger hikes are coming in the near future.

"Before the Fed went ahead and raised by a half-point, it would probably choose to eliminate the measured language," said Oscar Gonzalez, an economist with MFC Global Investment Management.

In addition, there just doesn't seem to be enough evidence yet to suggest the economy is in danger of overheating.

Mark Vitner, chief economist of Wachovia, said the Fed would probably like to see the federal funds rate at about 4.25 percent by the end of the year, in order to achieve a so-called "neutral" rate that would combat inflation without curtailing economic growth.

In order to get there, the most reasonable scenario would be for the Fed to raise rates a quarter-point at every meeting this year, he said.

But if the Fed were to move more rapidly to get to this target, Vitner argued, that might cause a spike in delinquencies on both residential and commercial mortgages, which would obviously have a negative impact on banks. And the Fed would probably like to avoid that.

"The Fed has to conduct a bit of a high wire act. If rates were to rise quickly that would put part of the economic expansion at risk, particularly residential construction and commercial development." Vitner said.

Eyeing inflation, job growth
That said, there are still some inflationary pressures out there. Oil prices, for example, are back near $50 a barrel.

"I don't think recent price data suggests that inflation is dead," said Gonzalez. "The Fed has to worry about whether or not it is keeping inflation under control and it would probably like to err on the side of caution."

But Zandi said the recent volatility in oil has to do more with the cold wave sweeping much of the country in recent weeks, and that the Fed won't put too much emphasis on this latest spike.

He said the key to whether the Fed will abandon its "measured" pace lies more with how the job market is shaping up. As long as hiring stays relatively sluggish, there's no need to worry too much about inflation, he said.

To that end, figures for January will be released Friday and economists are currently expecting a payroll increase of 200,000.

"That's right where the Fed would like to see it," said Zandi. "It would take a good year of that level of monthly growth before the job market tightens to the degree where inflation concerns would become more paramount."

Of course, the Fed won't have the luxury of knowing the exact January employment figures when it meets. So regardless of what the Fed says on Wednesday, investors will probably need to wait until Friday's job report to get a truer sense of what might happen at the Fed's next meeting on March 22.