Risks abound as Fed begins rate hikes

Federal Reserve Chairman Alan Greenspan and his fellow central bankers Wednesday launched what perhaps is the most important series of interest rate hikes in a decade. The decision marks a historic turning point that will push the economy into a new period fraught with risk, according to MSNBC.com’s semiannual economic roundtable.

At the conclusion of a two-day meeting, Fed policy-makers announced a quarter-point hike in the benchmark overnight lending rate, pushing it up from its lowest level in 46 years. The Fed is expected to continue raising rates, probably a quarter-point at a time, well into 2005. The risk is that a surge in inflation could force the Fed to raise rates faster and higher, choking off an economic expansion that is just beginning to hit its stride.

Harris

“There is a huge difference between the Fed gently removing its foot from the accelerator as inflation picks up to a moderate level … and the scenario where  inflation is uncomfortably high and the Fed feels it has to start hitting the brakes in earnest,” said Ethan Harris, chief U.S. economist for Lehman Bros.

Greenspan and other central bankers repeatedly have said they plan a “measured” approach to raising rates back to what are considered more normal levels. But the policy-makers also have hinted that they have a “Plan B,” Harris and others noted.

Leamer

“I think there are two scenarios here, and the driver is inflation,” said Ed Leamer, director of the UCLA Anderson Business Forecast. “If inflation stays tepid the Fed, recognizing that the market for homes and cars is fragile, will raise rates very slowly, less than the markets currently expect.”

But if inflation gets a foothold, all bets are off. Interest rates are likely to surge across the board, which would imperil both the housing and automotive sector “and possibly tip the U.S. into recession in 2006,” Leamer said.

Fueling this kind of speculation is the fact that inflation has staged a modest comeback this year, fueled by skyrocketing prices for gasoline and milk, among other products. Even excluding the surge in food and energy prices, which already is abating, so-called "core" consumer prices are up 1.7 percent over year-earlier levels, a startling increase from the 1.1 percent rate that prevailed in January.

Some economists say the surge in inflation is just what the Fed was hoping for when it lowered short-term rates to their current rock-bottom levels in June 2003. Back then many economists and policy-makers were concerned about the possibility of deflation, a destabilizing downward spiral of prices like the one experienced by Japan over the past decade.

Lereah

“I think the Fed was worried when it was at 1 (percent) or 1.2 that we didn’t have enough inflation throughout the economy,” said David Lereah, chief economist for the National Association of Realtors. “So to have the core rising at about 2 percent is fine. I think that’s healthy for the economy, especially a growing economy, a very robust economy.”

But Harris said the sudden surge in consumer inflation, like the “flipping of a switch,” has him and many other forecasters scratching their heads.

About the panel MSNBC.com’s semiannual virtual economic roundtable includes seven leading economists from Wall Street, the private sector and academia. As a standing feature, we republish forecasters’ previous projections to assess their accuracy. Click here to review the December 2003 roundtable.

“There is a little bit of puzzlement frankly about why inflation has been as strong as it has,” Harris said. “I think that the next several months will tell us a lot about how much of this inflation scare is legitimate and how much isn’t.”

On average, the seven panelists on MSNBC.com’s roundtable are looking for consumer prices to rise 2.6 percent this year, up from a forecast of 1.7 percent in December. Last year the Consumer Price Index rose just 1.4 percent. Most panelists highlighted inflation, the Fed tightening cycle or both as the biggest risks facing the economy.

Swonk

Diane Swonk, chief economist at Bank One in Chicago, said the economy should be in a “real sweet spot” over the next 18 to 24 months, but after that she fears the expansion could crumble under the pressure of “structural deficits,” including the rising federal budget deficit.

“This is a really a fundamental turning point,” Swonk said. “The last 15 to 20 years have been a period of pretty much slowing inflation and falling interest rates.” That period appears to be over, she said.

“We’re going from tepid water to warm water — not getting boiled yet by inflation, but it’s moving into a very comfortable period,” Swonk said. “Beyond that though I think we have to look at what price we are paying to get the gains we are going to see over the next couple of years.”

Rising interest rates are considered bad for the stock market, but fear of the Fed is not the only reason stocks have been stalled for months, the MSNBC panelists said.

Sohn

“What's been hurting the stock market obviously are the three negatives — the higher price of oil, the expectation of higher interest rates and the increased value of the dollar,” said Sung Won Sohn, chief economist at Wells Fargo.

“Over the long term I’m optimistic about the stock market,” he said, citing the growing economy and rising corporate profits. But over the short term, the stock market is stuck in a “tug of war,” with no clear trend apparent.

Other factors also might be hurting the stock market — including the war in Iraq, which appears to be taking a toll on consumer confidence, some analysts said.

Thayer

Gary Thayer, chief economist at A.G. Edwards, said the lack of confidence is the main problem afflicting stock prices.

“If we get some good news on the economy and confidence starts to come up we could see the market catch up to some of the good earnings numbers we have seen,” he said. “So we’re looking for a potentially good market through the end of the year. That assumes that we don’t have a major disruption or anything like that.”

Rosenberg

David Rosenberg, chief North American economist for Merrill Lynch, said the concerns about inflation are overblown, and he believes financial markets already have priced in more tightening that will be needed.

“If I'm right on the Fed, I’m right on inflation — core inflation is not going to become the big problem,” he said. “If the market can accept that, and that will take I think several months of good CPI data, then there is no reason to be bearish on the markets.”

Next: How is the economy likely to factor into the presidential election?

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