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Rate rise a fait accompli
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August 23, 1999: 7:49 p.m. ET
Analysts see one more inflation-stifling economy-slowing move by the Fed
By Staff Writer M. Corey Goldman
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NEW YORK (CNNfn) - Once again, the market has taken the liberty of deciding on Federal Reserve Chairman Alan Greenspan's behalf which way interest rates should go. Up.
Most analysts, economists and investors expect the Federal Open Market Committee -- the arm of the Fed that decides where interest rates should be - will press the red button a second time Tuesday and nudge short-term interest rates up a quarter notch to 5.25 percent, a move that will make borrowing more costly for consumers and businesses and slow the economy down.
The more pressing issue for financial markets now, it seems, is whether more rate increases will be on the Fed's agenda down the road, particularly in October and December, or whether just one more tap on the brakes will be enough to slow the U.S. economy and keep inflation under wraps.
"There seems very little doubt that the Fed will go a quarter-point," said William Dudley, chief economist of Goldman Sachs Co. in New York. "There is no evidence of inflation pressures yet, so the Fed can afford to be patient if they want to, but I don't think they want to wait around for problems."
Markets are ready
The bond market is more than ready for a rate hike. Yields on benchmark 30-year Treasurys surged to 6.28 percent last week, the highest in almost two years, on expectations that inflation is around the corner. Bond investors aren't keen on inflation because it erodes the fixed value of their investment. Yields now rest just under 6 percent.
The stock market is ready, too. For more than two weeks the Dow Jones industrial average has see-sawed between 10,700 and 11,100 as investors weighed the chances of another rate rise -- and whether it would be only a one-time event. On Monday the Dow surged to a new intraday record on expectations that Tuesday's rate rise, should it occur, will be the last for some time. Higher rates tend to erode corporate profits.
One thing players on both sides know as fact: With almost every American working, with wages rising, with stocks soaring, with international economies rebounding, with imports surging and with wholesale and retail prices seemingly ready to take off, Greenspan needs to give the choker around the U.S. economy's neck another love tug.
No more crises
"There is very little evidence that the momentum of the economy is slowing at all," Dudley said.
One of the biggest arguments economists have for another Fed rate rise is the lack of a major financial crisis, a good thing in most people's minds, but a bad thing from a financial market point of view.
In 1997, just as the Fed was bracing to raise rates and slow the economy, the Asian financial crisis hit, severely depressing commodity prices and significantly denting demand for U.S. goods abroad. To compensate, the Fed ended up lowering rates three times, from 5.5 percent to 4.75 percent in three successive moves.
Many economists believe the fed-funds rate is headed back to where it started -- 5.75%
In 1998, Russia's currency and debt crisis, among other global economic events, prompted the Fed to hold off raising rates as U.S. economic strength, driven by the zest of the American consumer, helped drive global economies to recovery.
And in 1999?
"Nothing has happened beyond the U.S. border to offset the U.S. economy's strength," said Doug Porter, a senior economist with Toronto-based brokerage Nesbitt Burns Inc.
Indeed, economies in the Far East are showing signs of recovery. Europe is doing better, particularly Germany, the largest economy on the continent. South America's economic outlook has improved, as has Mexico's.
Fed-fueled recovery
Part of the global recovery has come courtesy of the Fed's previous rate reductions and the robust spending habits its afforded U.S. consumers, who have grown increasingly fond of imported goods, services and investments. That fondness showed up in June's record $24.6 billion trade deficit.
"Inflation is not necessarily showing up yet, but I don't think the Fed wants to wait around to see the whites of its eyes," Porter said. "It's gotten to a point where the U.S. economy is displaying so much strength that the market is almost telling the Fed it should act."
An increase in the fed-funds rate, the target imposed by the Fed that commercial banks use as a guideline for overnight loans to each other, leads banks to raise the rate they charge on consumer loans, credit cards and other lending. That, in turn, slows economic growth by encouraging people to spend less and sock more away. It also slows business activity by raising the cost of borrowing.
And as much as it may hurt to spoil the party, that's likely what the Fed wants to do. In remarks to Congress last month, Greenspan addressed the robust U.S. job market and his concern that, with the pool of available workers shrinking rapidly, employers would have little choice but to raise wages to keep the talent they have on staff and to entice new personnel through their doors.
Keeping it cool
"The already shrunken pool of job-seekers and considerable strength of aggregate demand suggest that the Federal Reserve will need to be especially alert to inflation risks," Greenspan said in his semi-annual Humphrey-Hawkins testimony last month. "Should productivity fail to continue to accelerate and demand growth persist or strengthen, the economy could overheat."
Since then, little evidence has emerged that the strength of the U.S. labor force is diminishing. The number of jobs added to the economy rose by 310,000 in July, almost double what economists had anticipated, with the unemployment rate holding steady near a generation low of 4.3 percent.
And wages are definitely on the rise. Average hourly wages, which takes what people across the country make per hour and averages it out, rose 0.5 percent to $13.29 last month.
"No matter how you slice it, we've seen some acceleration in labor costs," said David Jones, chief economist with Aubrey G. Lanston in New York. "The market took heart from good producer and consumer price numbers, but I don't think Greenspan is paying as much attention to those numbers as the Street has."
Signs of slowing?
And they were pretty good numbers. Since spiking up 0.7 percent in April, consumer prices have remained extremely benign, ringing in last month at a tame 0.3 percent. Producers' costs, too, have remained surprisingly low, leading some economists to question whether a fire that hasn't started yet needs to be snuffed out.
What's more, mortgage rates already have risen, retail sales have begun to taper off and consumer confidence, while rosy, isn't as rosy as it was six months ago, suggesting consumer spending, which accounts for about two-thirds of the U.S. economy's strength, may be starting to wane.
Financial markets see things that way too, which is why they're pricing in only one more quarter-point rate rise. The December fed funds futures contract, which indicates where investors expect the fed funds target to be at the end of the year, carries an implied yield of 5.38 percent, suggesting few investors expect rates to rise higher after Tuesday. Earlier in the month the yield was at 5.49 percent, suggesting two quarter-point rate hikes.
But Goldman Sachs' Dudley is a little more cautious than that.
"It's possible we'll see at least one more rate increase in November and we could see another one or two after that if things don't slow down," Dudley said. "It may take that much to convince consumers and the stock market to take a breather." 
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