It’s time for the Fed to raise rates again

It’s time for the Fed to raise rates again
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First Published: Fri, May 11 2007. 12 06 AM IST
Updated: Fri, May 11 2007. 12 06 AM IST
When the US central bank stopped ratcheting up rates last August, its decision to hold Fed funds at 5.25% seemed plausible. The stock market had hiccupped in May and some believed that the Fed’s steady programme of quarter-point increases needed time to work through the economy to suppress inflation. Nine months later, with the stock market up 15%, that justification has evaporated. It’s now time for the Fed to do something about what it calls its “predominant policy concern”.
Unfortunately, the Fed’s earlier rate hikes appear to have slowed the economy without reducing inflation. Gross domestic product (GDP) growth in the first quarter was only 1.3%. Since US population grows at 1% a year, that’s near recessionary levels. However, job growth remains buoyant and unemployment low, due to sluggish productivity growth. So the interest rate cuts which a slowdown would normally mandate—and which Wall Street has been anticipating since last autumn—can’t be justified by any slack in the economy.
Meanwhile, the Fed admits core consumer price inflation remains “somewhat elevated”, at 2.1%. However, when food and energy costs are included, inflation as measured by the GDP deflator is 4%, making the 5.25% Fed funds rate, and especially the 4.67% 10-year Treasury yield, look low when compared with historically neutral real rates of 2-3%.
Globally, commodity and energy supplies remain tight and may be tightening, so inflationary pressures could intensify. And the anti-inflationary effect of outsourcing services to India and importing goods from China may be waning. Both those countries are suffering inflationary pressures of their own. The traditional reason for not raising rates too much is that it could destroy financial market confidence. But the US stock market is at record levels. Market confidence is extraordinarily high, as the continuing availability of funding for aggressive private-equity transactions shows.
With the US economy slowing, the Fed may fear that a rate increase will cause it to be blamed for a recession, particularly by Wall Street’s bonus hounds, who will be left licking their wounds. But in light of the growing pressures, that’s a poor reason for not raising rates.
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First Published: Fri, May 11 2007. 12 06 AM IST
More Topics: Money Matters | Global Markets |