Signals mixed on US interest rates

The Fed is tightening, but long-term rates aren't keeping up. Some worry it means that economic growth will slow.

Interest rate forecasting has now become almost as difficult as predicting the path of a hurricane.

Even after the Federal Reserve raised interest rates 0.25 percentage points last week, there is now a wide disagreement over whether rates will be rising or falling next year, reflecting a split over the pace of future economic activity.

The pessimists expect economic growth to slow in 2005, although they don't project a recession. The overall bond market now seems to be in this pessimistic camp. Professional bond traders haven't pushed long-term interest rates up on pace with the Fed's tightening of short-term rates. In effect, the bond market seems to signal a slowing economy that will put a damper on the Fed's rate hikes.

The optimists, however, foresee the economy skipping along at a relatively brisk pace that would be powerful enough to cause the Fed to continue raising rates through the year.

"The forecasts are all over the map," says Jose Rasco, an economist with Merrill Lynch & Co.

The difference in terms of the future direction of rates is fairly wide. Economists in the glum camp see 10-year treasuries paying less than 4 percent interest next year - down from 4.25 percent currently. The optimists foresee those same rates rising close to 6 percent.

"The spread is as wide as I can remember in the last 25 years," says Sung Won Sohn, chief economist at Wells Fargo Banks in Minneapolis. "That's because we're at a turning point where interest rates that have been declining are now beginning to rise in what could be a major trend."

Impact on housing market

There are widespread implications for either forecast. For example, the housing market is one of the most interest-rate sensitive areas of the economy. As interest rates rise, fewer consumers qualify for loans or even bother applying for them. If the economy does not improve as rates are being raised, it could mean as many as 250,000 new homes would not get built, says Michael Carliner, an economist at the National Association of Home Builders.

And in a growing economy, rising rates may make it harder for some people to afford a mortgage. Consider a $200,000 loan. A monthly payment that is $1,412 at a 7.6 percent mortgage rate would be $1,136 if the mortgage rate is 5.6 percent.

"It might disqualify some and others might be unwilling to pay it," says Mr. Carliner. "However, interest rates are less sensitive than in the past because the awareness and cost of refinancing has changed so people are willing to buy now and if the rates fall, get a new mortgage."

Trading amid storms

The different rate scenarios could make a major difference in the direction of the stock market as well. Mr. Sohn sees rising interest rates as a lid on stock prices. He's recommending that investors sell into any rally. "We're unlikely to have a bull market based on my scenario," says Sohn, who anticipates the 10-year treasury at the end of 2005 will be closer to 5.5 percent. "The stock market's expectation right now is that interest rates will go up more quickly."

Some economists are advising the Fed to move cautiously, however, especially considering the stresses placed on the economy by the series of hurricanes that have rolled through Florida. Economic data could be dampened by the fierce storms. Construction projects have been delayed and many people along the East Coast couldn't get to work because of floods and electrical outages. Even the unemployment survey, due out on Oct. 8, could be distorted.

"The September data could get knocked down a little bit," says Scott Pedowitz, an economist at Commerzbank Securities in New York.

Despite the storms, Mr. Pedowitz expects that Fed will hike interest rates a quarter point one more time when it meets on Nov. 10. This would eliminate the "emergency" reductions the Fed embarked on after 9/11. After this move, Pedowitz expects the Fed will slow its rate increases to one per quarter. This would increase short-term rates another 1 percent next year.

Energy and consumers

There are lots of reasons why such forecasts are harder to make. For example, the price of oil has remained higher than most economists, and the government, have expected. High oil prices may act like a tax increase on consumers. "On the margin it may mean you buy three Game Boys instead of four," says Merrill Lynch economist Stan Shipley. "No doubt it will eat into consumer spending."

The damage could be particularly noticeable this winter because the price of home heating oil, natural gas, and propane are all considerably higher than last year. But, Mr. Shipley says, "over time you learn to move the thermostat down, put up storm windows, and change your behavior."

Higher energy prices - and inflation - fit into the argument for those who think the Fed will tighten rates. "When we have a healthier economic outlook with rising inflation, the Fed will be more aggressive," says Sohn.

Rasco, however, wants to know where the healthier economic outlook comes from. "The economy is not accelerating meaningfully," he adds.

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