Analyst: Fed Could Hike Rates to 7% by Mid-2011

Yesterday, CNBC reported that John Lekas, CEO and portfolio manager of Leader Capital indicated that the Federal Reserve could raise the benchmark federal funds rate to 7% by the Second Quarter in 2011. “We think the Fed will take [interest rates] to almost 7 percent by the second quarter of 2011. That’s based on weak GDP and continuing deterioration of the dollar, which is inflationary.”

Currently, the Federal Reserve’s target rate for the federal funds rate is 0.00% to 0.25%. Since 1971, the Federal Reserve has increased its benchmark rate by 500 or more basis points within two years on three occasions: July 1973, August 1979, and November 1980. In each case, the nation was confronted either by high inflation or rapidly rising inflation.



Despite the enormous fiscal and monetary stimulus that has been applied, during what has been the steepest recession of the post-World War II era, a number of factors suggest that inflation will likely remain relatively tame over the next 1-2 years. Those factors include:

• A relatively high unemployment rate. The high unemployment rate will create sufficient labor market slack so as to avoid any significant increase in wages.

• Financial system weakness. In the wake of the housing bubble and in the face of rising consumer delinquencies and defaults, the nation’s financial system remains under pressure. As a result, credit creation is likely to be less robust than it was during recent decades.

• During U-shaped recoveries, real GDP has averaged 2.1% growth in the first year following the trough in GDP and 3.5% over two years from the trough. Such growth is not likely to trigger a major outbreak of inflation.

• Household deleveraging will likely restrain the growth of personal consumption expenditures. More modest consumption than might otherwise be the case should also dampen inflationary pressures.

• With inflation remaining relatively contained over the next two years, expectations for future inflation should also remain anchored. Typically, expectations for inflation during the year ahead largely reflect inflation that has occurred during the past 6-24 months.

All said, unless significant or rapidly rising inflation materializes over the next two years, the Fed’s post-recession interest rate hikes will likely bring about a gradual increase in rates. Right now, it appears that the case against significant or rapidly rising inflation remains somewhat more likely than the high inflation outcome. Factors that could change that outcome would include a failure by the federal government to develop a credible budget deficit reduction program following the return of sustained economic growth, the inability of the Federal Reserve to wind down its balance sheet once sustained economic growth is underway, the onset of much more rapid economic growth than appears likely, a substantial energy price shock, and/or the adoption of programs that could markedly increase the nation’s structural budget deficits.

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