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Between the Lines

June 30, 2004

Derailing the free-money gravy train

The Federal Reserve Board raised short-term interest rates by one-quarter of a percentage point today to 1.25 percent. No surprise; everyone knew it was going to happen. And, by itself, no big deal, either.

However, the Fed's action almost certainly signals that the gusher of free money that kept the economy from falling into a deflationary recession after the stock market crash is about to be sopped up. A single quarter-point increase in interest rates means nothing. But it is a harbinger of several additional rate increases in the months ahead. Economists already are predicting that the fed will increase short term rates to between 3.5 percent and 4.5 percent by the middle of next year (or 2.5 to 3.5 percentage points higher than where they were until today).

When short-term rates increase, banks usually raise their so-called "prime rate" in lockstep with the Fed. Consumers will begin to notice this because most credit-card rates and many consumer loans are based on the prime rate plus several percentage points of interest that the banks skim off for themselves. An increase of 2.5 to 3.5 percentage points in these rates will have a noticeable impact on the size of monthly installment payments.

More significantly for the economy here in the Puget Sound area, rising interest rates will equal further increases in mortgage rates, which have already jumped from a low of around 5.25 percent last year to around 6.25 percent now for a conventional 30-year fixed mortgage. Despite the increases, home sales and housing prices have remained hot downright bubble-like, in fact -- so far. But there is, no doubt, a limit and we're probably approaching it. Wall Street economists think the mortgage rate will rise to around 6.6 percent by the end of the year and inch incrementally higher next year.

If rates rise much more than forecast, the likely bottom line will be, at best, static home prices and at worst another popped bubble. People who have refinanced to drain equity from their homes for other purposes (to take advantage of those 0% auto loans, for example), and those with adjustable-rate mortgages, could be caught in a nasty squeeze if housing prices actually decline.

Of course, we won't know the bottom line on that for, perhaps, a year or more. And it is possible that some modest increases in interest rates now will forestall the need for the more dramatic increases that would be more likely to deflate housing prices.

History, however, shows that once the fed begins to raise interest rates, the level at which they ultimately settle tends to be higher than most people expect. And if the Fed finds it necessary to jack rates up substantially in order to contain inflation another side effect will be a struggling, and probably declining, stock market (it takes more than one or two rate increases to kill off a rising market of the kind we've seen for the last year, but sharp increases generally lead to bear markets).

The Fed ever concerned about roiling the stock market and, heaven forbid, actually being blamed for it painted a rosy picture around today's action:

"The [Federal Open Market] Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. The evidence indicates that output is continuing to expand at a solid pace and labor market conditions have improved."

All well and good. However, there also was this observation: "Although incoming inflation data are somewhat elevated, a portion of the increase in recent months appears to have been due to transitory factors." Translation: Inflation may be about to break out, which would require faster, larger rate increases, but we've got our fingers crossed.

There is, in fact, evidence that inflation is rapidly becoming somewhat less benign. Inflation hit its low for the present cycle last fall. Here's what's happened to the annualized rate of inflation since:

Nov. 2003: 1.77%
Dec. 2003: 1.88%
Jan. 2004: 1.93%
Feb. 2004: 1.69%
Mar. 2004: 1.74%
Apr. 2004: 2.29%
May 2004: 3.05%

The pattern is pretty obvious. Inflation is accelerating. It's nowhere near out of control, but it's going up, and interest rates will go up until it appears inflation is settling in at an "acceptable" level.

There is a bright side to the interest rate increases. Certificates of deposit, money-market funds and saving accounts and short- and medium-term bonds will begin to yield more. This encourages saving, which this country desperately needs more of, and helps people on fixed incomes (but only if interest rates are higher than the underlying inflation rate).

Enough for now. We're entering a new phase for the cost of money, and thus for the economy. It will take some time to see how it plays out. But for now, caution would be a virtue in taking on new commitments.

Posted by tbrown at 02:25 PM

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Derailing the free-money gravy train


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