The Fed's Coming Rate Hikes

A lot of people seem to be watching the Fed Funds futures contract these days. I'm no expert in how to read it, but the consensus seems to be that if the market is right, the Fed will hold steady in June, raise by 25bp in August, and then raise another 25bp in either September or October, bringing us back to 2.5% by November.

A rising-interest-rate environment would help put a floor under the dollar (is the hope) and help to dampen fears about non-oil inflation picking up. It would also act as a signal from the Federal Reserve that the financial crisis is over, and that the Fed no longer needs to set very low rates in the hope of getting liquidity to start flowing around the banking system again.

The downside? Well, higher interest rates can't be good for equities. Martin Hutchinson of Breaking Views made the interesting point this week that since 1995 or so US stocks have risen in line with the amount of money in the economy, and not with GDP. It makes sense that insofar as Bernanke has turned on the spigots over the past year, that has helped to minimize the natural decline in stocks which one would expect heading into a recession. Without that monetary help, stocks might look significantly less buoyant.

Would the economy more broadly be hit by a 50bp hike by November? I somehow doubt it. Companies aren't really borrowing right now, and the reason they're not borrowing is entirely a function of bank liquidity, rather than a function of high interest rates.

And a Fed funds rate at 2.5% is still very much on the easy side of neutral. Bernanke would still have his foot on the gas pedal rather than the brake, he just wouldn't be flooring it.

There's also, however, the question of Bernanke's vanity. Let's say there's another sickening lurch in credit markets, or the stock market falls by 8% in two days, or a major financial institution (it doesn't need to be Lehman; it could be, say, Freddie Mac, or even conceivably Countrywide, if Bank of America backs off) implodes. At that point, the Fed would be inclined to come swinging to the rescue with another emergency rate cut - but it's well known that central banks, like ratings agencies, hate to wobble. They're going up, or they're going down, or they're holding steady. They don't zig-zag.

But the good news here is that Bernanke isn't that vain, and he might even welcome the extra room for maneuver which a slightly higher Fed funds rate would give him.

So my feeling is that now Bernanke is sounding increasingly hawkish, it's quite easy to get behind the idea that we're entering a rising-interest-rate environment. Nothing's going to happen at the meeting this month, most likely, which means the Fed will be able to wait and see what happens through all of July before finally pulling the trigger on a 25bp increase on August 5. Right in the middle of what is certain to be a hotly-contested presidential election campaign in which the economy is Issue Number One. Ah, timing.

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