Rate Hikes May Be Around the Corner

Following the collapse of Fannie Mae and Freddie Mac, Ben Bernanke's Congressional testimony last week had Fed watchers predicting interest rates would remain flat, or possibly fall, by the end of the year.

But surging share prices last week and tough talk from two FOMC board members has delivered an expectations U-turn.

According to interest rate futures, investors had priced in a 42 percent chance of a 2008 rate hike following Bernanke's testimony. But after falling oil prices and not-as-horrible-as-expected earnings from banks drove stocks higher through Thursday, a hike by year-end had been fully priced in by finicky investors.

Then on Friday, Minneapolis Fed President Gary Stern said that the Fed couldn't wait for the double-threat posed by jittery housing and financial markets to subside in order to fight higher inflation. In similar remarks, the Philadelphia Fed's Richard Plosser said this morning that rate hikes should be expected "sooner rather than later."

Adding to the mix, the Financial Times fronted a story with the headline "Fed appears to focus on inflation ahead of growth":

In effect the Fed has moved from doing whatever it can to support growth, subject to an inflation constraint, to seeking to start raising rates as soon as it can, subject to a growth constraint.

All of this has helped pushed up the expectations of higher rates even further with a hike by October almost fully priced in at 90 percent.

Still, it's important to note that Plosser and Stern are tried-and-true inflation hawks as well being regional bank presidents. The reason the latter distinction is important is that there appears to be a growing argument over price pressures within the Fed between those in D.C. and those at the regionals. Tomorrow's Beige Book release will likely tell us how bad the inflation picture is in different parts of the country.

A regional-D.C. divide likely means that there will be three dissenting votes at August's FOMC meeting with Plosser and Stern joining the Dallas Fed's Richard Fisher in calling for a rate hike, say Lehman Brothers economists. Fisher has already dissented four times this year and it would be the first time since 1992 that three FOMC members have voted against the majority.

And not everyone is on board with a 2008 fed funds rate increase. Looking back at the last two fed cycles, economists at Wrightson ICAP write in a note that it's too early to think about a possible hike:

At this point in the 2001-03 easing, we were still a year and a half and 100 basis points away from the final rate cut. In the 1990-92 easing, we were 16 months and 275 basis points ahead of the bottom in the policy cycle. If judged solely on the basis of historical patterns, the funds target would seem more likely to reach 1% by next summer than 3%.

But if you believe that inflation around the world is going to get worse, a hawkish Fed would be most welcome. A recent paper by Matteo Ciccarelli of the European Central Bank and Benoît Mojon of the Chicago Federal Reserve finds that since 1960, inflation has been largely a global phenomenon among developed countries, accounting for about 70 percent of the variation in each country's price measures. Ciccarelli and Mojon write:

Countries that have experienced stronger commitment to price stability are less affected than those with weaker inflation discipline.

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