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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FOMC’s August 12 Monetary Policy Statement: No Rate Change, but Somewhat More Upbeat

On Wednesday, August 12, the Federal Reserve’s Federal Open Market Committee (FOMC) will very likely hold the federal funds rate steady in the 0.00% to 0.25% range. Signaling continuity with current interest rate policy, Federal Reserve Chairman Ben Bernanke told the House of Representatives’ Committee on Financial Services on July 21, “The FOMC anticipates that economic conditions are likely to warrant maintaining the federal funds rate at exceptionally low levels for an extended period.”

Nevertheless, the FOMC’s forthcoming policy statement will likely reflect a combination of sentiments that are similar to recent monetary policy statements, along with some subtle changes in wording to reflect the continuing stabilization of the U.S. economy and prospects for modest growth through the rest of 2009. Overall, the statement will be somewhat more upbeat than the prior one, but it is unlikely to contain any hints of upcoming interest rate hikes or concerns about rising inflation.

Overall, one can likely expect the following in the FOMC’s forthcoming monetary policy statement:

• That the pace of economic contraction has slowed significantly and that economic activity is showing some indications of stabilizing. It may also note some enhancement in economic prospects. That wording will constitute an improvement over the FOMC’s June 24 statement in which it observed that “the pace of economic contraction is slowing.”

• That the housing market has shown additional signs of stabilizing.

• Household spending has remained fairly stable, but is constrained by continuing weakness in the labor market.

• Anticipation that “policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.”

• Modest growth in economic activity is likely during the remainder of the year.

• That inflation will remain “subdued.”

• The FOMC “will employ all available tools to promote economic recovery and to preserve price stability,” “will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets,” and that it will monitor “the size and composition of its balance sheet” and make such adjustments as might be warranted.

• Economic conditions will “likely warrant exceptionally low levels of the federal funds rate for an extended period.”

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