Dangerous Curve Ahead

October 21, 2005
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KALAMAZOO — The Federal Reserve Board is expected to bump the fund rate another quarter of a point Nov. 1, a move that would hike the key overnight short-term lending rate from 3.75 percent to 4 percent.

If that happens, it would be the 12th consecutive increase the board will have taken at its policy-making meetings since June of 2004 — when the fund rate stood at 1 percent.

Most analysts and economists feel board members see next year as a growth year for the economy, especially starting in the second quarter when the rebuilding of the hurricane-devastated areas will be under way and will begin to raise the Gross Domestic Product.

And because of that projected growth, they believe the board will raise the fund rate to combat an expected inflationary hike in prices.

But George Erickcek, senior regional analyst with the W.E. Upjohn Institute for Employment Research, says the major inflationary concern isn’t the drastic rise in crude prices, what economists call a “cost push.” Instead, Erickcek felt it’s the potential for a “demand pull” that has grabbed the attention of most experts.

“When we have an increase in oil prices, you get this price bump and that goes through the system. But the thing is, is that cost-push inflation is a one-time event and it’s over,” said Erickcek. “That type of inflation is not as worrisome as inflation expectations, a mentality that expects prices to continue to climb. That happens with demand pull.”

Demand pull occurs when economic activity is up, as is forecast for 2006, and business executives feel they can raise prices that will stick because customers are too busy to notice.

“Then you get kind of an inflationary cycle going: When someone raises prices, someone else raises theirs. That type of activity, which is separate from cost and more driven by demand, is the type of inflation that I think the Fed is worried about,” said Erickcek.

But the forecast for growth in 2006 isn’t carved in stone. Wavering consumer confidence, a lack of saving by consumers, and too many homeowners relying too much on their home-equity loans have hedged some of the bets that the economy will grow next year.

“Given the fact that we seem to be taking money out of our homes on the assumption that prices will continue to grow, the possibility of the housing bubble popping, I think, is making many economists a little bit nervous,” said Erickcek.

“You look at that with the debt situation — what is going to happen with the national debt. But even if the forecast is correct, the uncertainty surrounding the forecast has only grown. I think there is a growing sentiment among some economists that maybe the Fed should hold off on that expected bump until that uncertainty clears,” he added.

Erickcek and others are concerned that another fund-rate hike would raise short-term interest rates, which are dangerously close to exceeding long-term rates right now. When a short-term rate, such as the payout on a 90-day Treasury note, is higher than the rate on a 10-year Treasury bill, an inverted-yield curve is born.

“The one, true indicator that has never lied to us has been the interest-rate spread between long-term and short-term rates. That spread has been closing — and been closing rather rapidly,” said Erickcek.

The curve has been an accurate predictor of recessions. The last reversed arc popped up in December 2000 and the economy began to tank shortly after. Economists like to see a 2.5 percent spread between short-term and long-term rates. But a gap of anywhere near that size hasn’t existed all year, and the separation between the two rates has been less than 1 percent since June. (See related chart.)

“I think it’s an indicator that the Fed should slow down,” he said. “The tightness shows a contractionary quality, and you kind of worry about that.”

So should a business borrow now for that piece of equipment or expansion project, or wait six months? Erickcek felt that decision shouldn’t be based on interest rates as much as what that new facility or piece of machinery can add to the profits.

“My feeling is, it isn’t interest rates that businesses should be looking at; it’s the forecast of future activity. There, unfortunately because of the events of the last three or four months, the level of uncertainty has only climbed,” he said.

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