Tuesday, February 21, 2006

The Conundrum around interest rates

There is one question that is prominent in the minds of anyone who takes even a passing interest in the affairs of Wall Street. And it is this – How long and how much would Mr. Ben Bernanke, the new Federal Reserve Chairman, continue to raise the Fed Funds rate? The concern is legitimate, for the supply of money in the economy, which the Fed attempts to control through the Fed Funds rate, determines to a large extent the potential growth that American economy can exhibit in the coming year.

The Fed Funds rate is the rate that the Federal Reserve charges to lend money to its member banks. If the rate is low, member banks would have incentive to borrow money at a cheaper rate and lend it to their borrowers at a higher rate and pocket the difference (called the carry spread). The borrowers, in turn, would take more loans (perhaps to construct that extra plant, or buy an extra house) when they have to pay lower rates. As such, the Federal Reserve lowers Fed Funds rate when it perceives that the economy is slowing down and might perhaps go into a recession. On the other hand, the Fed increases rates when it feels that the economy is expanding at a faster rate than necessary (which might lead to inflation).

Following the Internet bubble burst in early 2000 and 9/11, the Fed dropped interest rates to historic lows of 1% in a succession of rate cuts by 2003. As the economy strengthened and gained momentum , the Fed started increasing rates beginning June 2004. In a succession of 14 rate hikes of 25 bps each, the Fed funds rate has climbed from 1.00% to 4.50%. It is widely perceived that Mr. Bernanke would increase the rates once more when he chairs the first meeting of the Fed since he took over from Mr. Alan Greenspan. But are there more rate increases after this, or will Mr. Bernanke be satisfied with the state of the economy and leave it at that?

That would most likely depend on the inflation numbers that the Fed measures going forward. While growth is important in an economy, it is even more important to contain inflation. For the biggest reason behind the economic expansion in US in the last 2 decades has been the ability of the Fed to control inflation effectively. Low inflation gives visibility to consumers and businesses visibility into wages and prices. As such, they are willing to take increased risks.

Measuring inflation is, however, not straightforward. Different measures of inflation, such as CPI (consumer price index), WPI (wholesale price index), GDP deflator etc. might give different pictures. Then again, these measures might include items (such as food prices and energy prices) that are more volatile, which might cause inflation numbers to be erratic month to month (Economists try to circumvent these problems by looking at inflation ex food and energy). The Fed also at various other metrics such as the rate of unemployment, capacity utilization etc to get a sense of inflation.

Most of the inflation numbers are currently benign. That makes the bulls argue that the Fed might stop raising rates after the next one. They point out that the economy grew at a mere 1.1% in the fourth quarter of 2005. Consumer spending was flat year on year in the all important holiday season. The house market has started cooling. With so many Americans depending on the home equity lines of borrowing to finance their spending over the last few years, any further increases in rates might cause the consumer to throttle back further, pushing the economy down, maybe into a recession.

Bears, however, contend that the various inflation measures systematically underestimate the real inflation in the economy. They also point out that the rate of unemployment is currently running at 4.70%, which is much higher than the normal rate of 5.0%. As such, it is very likely that wage pressures start building up in the economy (i.e. employees start demanding higher wages). And while the economy might have grown at 1.1% in fourth quarter, it is expected to rebound to 3%+ growth in the current one. They also point out the impact that high oil prices might have on core inflation.

The equity markets have remained range-bound in the last year and half, with the Dow Jones oscillating between 10000 and 11000 during this time-period. If the Fed decides to stop raising rates, the markets might move higher. But then, corporate profits have grown in double digits in the last 15 quarters – the longest streak that the US economy has had since World War II. Besides, this economic expansion has been driven by consumer spending and not business spending. The consumer is currently heavily indebted, the savings rate actually fell below at one time last year. Perhaps the consumer might slow down even if the Fed stopped raisi! ng rates, and business spending might not pick up enough to fill the gap. If that were to occur, one might not see the Dow crossing its all time high of 11, 722 hit on Jan 14, 2000 anytime soon.