Looking Beyond The Sunny Forecast
The Federal Reserve sees clear skies ahead, but the markets say otherwise. Whom should you trust?
By Daniel Altman

(Business 2.0) – Guessing where the economy is going is like predicting the weather—an iffy proposition at best. A case in point: the Federal Reserve, which since the middle of this year has been pushing up short-term interest rates. Short-term rates—the ones that banks charge each other for overnight loans—are the Fed's main tool for steering the country's finances, and steady increases are usually a sign that the economy is picking up steam. But long-term interest rates, which are controlled by the markets rather than the Fed, suggest a different outlook. Those rates, used for many small-business loans, mortgages, and lines of credit, have pretty much held steady all year. The message? Improved economic activity, and the heightened demand for credit that comes with it, may be a ways off.

From June to September, the Fed raised its target for short-term rates three times, for a total of 0.75 percentage points. In announcing the last jump, the Fed issued a statement that, translated from Fed-speak, said, "Because inflation isn't picking up too quickly, we can continue to raise interest rates gradually. But if prices start to jump, we'll lower the hammer."

With such a clear signal that short-term rates will eventually rise, you would expect long-term rates to climb along with them. After all, if you're going to lend someone money, and you know that short-term rates are only going to increase, you would probably ask for a higher long-term rate too. Why leave money on the table? Moreover, given the ballooning deficits in Washington, you'd expect long-term rates to rise even faster. All that borrowing by the government will make credit harder to come by.

But what if you think the economy will stall, despite what the Fed says? That means consumers will be spending less on goods and services, so businesses won't need to borrow in order to build capacity. With less demand for credit, long-term interest rates will fall.

And that may explain why long-term rates haven't risen along with short-term rates. Though they jumped in May in anticipation of the Fed's first move in June, long-term rates have now slipped back to where they started the year. Even if the Fed suggests that the economic forecast is partly sunny, the markets seem to see clouds on the horizon.

So if you own a business or you're trying to decide whether your company should invest for the future, whom should you trust? You don't want to be stuck with a lot of extra equipment, inventory, or even employees if the economy isn't booming six months from now. The best answer is to look around you. The Fed and the financial markets embody expectations from across the United States and the world. Yet chances are that your business depends on what's happening closer to home.

A good place to start is your local bank, which has a keen sense of your local economy's health. Check how its long-term interest rates compare with the rates being set on Wall Street, and track them to see whether they're rising or falling. Read the free research on the website of your local Federal Reserve Bank. These are better gauges of the economic climate your customers will be facing in the next year. Just like the weather, it won't be the same across the country.

Clouds on the Horizon

Long-term interest rates don't support the rosy outlook of their short-term counterparts. But they closely track the soberer expectations for inflation.

2004

Sources: Federal Reserve; University of Michigan consumer surveys